The Eliot Rose Blog
What’s the Actual Value of Contributing to an IRA or 401-K?
Added 12/13/2016 by Jason Siperstein, CFA, CFP
You are probably already aware of the importance of regularly contributing to your IRA (individual retirement account) or 401-K. But, have you ever quantified the value? How much do these tax-advantaged accounts actually save you in taxes?
First, let’s explain the difference between the tax treatment of these three accounts. A Roth IRA/Roth 401-K is invested with already taxed dollars, grows tax-free, and is withdrawn from its account tax-free. A traditional IRA/401-K, on the other hand, has the exact opposite tax treatment. It is invested with pre-tax dollars, grows tax-deferred, but when it is withdrawn, the entire sum is taxed at your ordinary income tax rate. Finally, a taxable account is funded with after-tax dollars, is taxed at either capital gains or ordinary income depending on the holding period, and is withdrawn tax-free. You can use the table below to use as a guide.
So back to the headline! The answer to this question depends primarily on the growth of your account. Simply put, the larger your account growth, the larger the benefit.
Let’s assume you contribute $100,000 in after-tax money to one of the accounts below. If you experience 450% account growth (about 7% per year for 25 years), you are left with 20% more in these tax-sheltered accounts (assuming 30% ordinary income tax rate and 20% capital gains tax rate).
However, if you only have 30% growth in your account the equation changes. If this is the case, you are left with only 5% more in the tax-sheltered accounts.
Bottom line –contribute early to achieve big growth to reap the maximum tax advantage!