Most employers provide their employees with retirement accounts such as 401k, 403b (non-profit), or Simple IRAs to allow sheltering of income to present taxes. If you are an independent contractor, you can open similar accounts for yourself.
The fundamental premise of these retirement accounts allow you to defer present income taxes until you withdraw these funds during retirement. These vehicles are advantageous with two assumptions:
- Your present marginal income tax rate is higher than your overall tax bracket in retirement.
- You have options to invest the funds within the account tax-deferred until withdrawal.
If these conditions aren’t fully met, the tax advantages of retirement accounts are lost.
For instance, as a hot-shot cardiothoracic surgeon salaried at $500,000, your federal marginal tax rate as a married filer is 39.6%. This means that the amount you make above the next highest bracket ($457,601) is taxed by Uncle Sam at 39.6%. If you invested $18,000 of that to a 403b account, your effective income is decreased by that amount and you don’t have to pay taxes on that $18,000 (yet). At a 39.6% federal rate, you “avoided” paying $7128 in federal taxes on that amount.
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In retirement when you withdraw your $18,000, you start filling the tax bracket at the 0, 10, 15% brackets. You will hopefully pay less than $7128 in taxes in the future than now simply because you aren’t making a $500,000 salary. Obviously if the income tax brackets are reconfigured such that you get taxed at a rate higher than your present marginal rate, you’re screwed.
Condition #2 means that you are growing that $18,000 at some respectable rate (hopefully beating inflation) that allows it to be equally or more meaningful when you use it during retirement.
Lastly, tax-deferred doesn’t mean tax-free. You will still have to pay taxes on your earnings when you take the money out!
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