Advantages of Retirement Accounts
A major advantage of tax-deferred investing is making contributions to a retirement account with pre-tax dollars. In many instances [e.g., 401(k) plans], the government allows taxable income to be reduced by the amount of the contribution to a tax-deferred retirement plan. As a result, you can have the same amount of money in your pocket and invest what you would have paid the government. For instance, if you are in the 22% marginal income tax bracket and you contribute $1,000 to a tax-deferred retirement plan, you would lower your federal income taxes by $220 (0.22 times $1,000). The savings is based on your marginal tax rate, i.e., the rate you pay on the highest dollar of earnings.
There are seven different tax rates in 2020— 10%, 12%, 22%, 24%, 32%, 35%, and 37%. The higher your marginal tax rate, the more you, as an investor, benefit from pre-tax dollar contributions to retirement savings plans and tax-deferred earnings. Figure 1 shows the 2020 tax rate schedules for your reference in determining marginal tax rates. These figures are adjusted annually for inflation.
Figure 1. 2020 Tax Rate Schedules
Head of household-Schedule Z
Married filing jointly or Qualifying widow(er) – Schedule Y-1
Married filing separately – Schedule Y-2
A second advantage of tax-deferred investing is that earnings grow faster because they aren’t taxed until withdrawn. Instead of paying tax on the interest earned, it continues to compound until the investment is sold. Over time, the gap between the value of a taxable and a tax-deferred account, earning the same rate of interest, increases sharply.