Printer Friendly

Q&A: non-deductible retirement contributions.

Q: The limit on how much I can contribute annually into my retirement account, on a deductible basis, is pretty low. Does it make sense to make contributions that are not tax deductible?

A: The short answer is, yes. Although additional contributions may have to come from after-tax income, the money contributed to your retirement account will earn and grow tax-free. Let's look at the tax-deferred income growth from an annual return point of view. In the table below, we show pre-tax equivalent returns of earning 8% in a tax-deferred account. The overall tax rate is an estimate of your total federal and state taxes.

The tax deferral enjoyed on income generated on after-tax retirement account contributions increases your comparable pre-tax return by 66% if you're in a 40% tax bracket, 54% in the 35% tax bracket, and 42% in the 30% tax bracket.

Your Overall   Annual   Pre-Tax          Bonus    Percent
Tax Rate       Return   Equivalent (1)   Return   Increase

40%            8%       13.3%            5.3%     66%
35%            8%       12.3%            4.3%     54%
30%            8%       11.4%            3.4%     43%

(1) Formula: Annual Return of 8% divided by 1.00 less tax rate
(0.40, 0.35, and 0.30).

The higher your tax bracket and tax rate, the more tax-advantageous it is for you to make voluntary contributions. Compare the 40% tax rate column (which yields a pre-equivalent return of 13.3%) with the 30% column (a pre-tax equivalent return of 11.4%). That's 1.9 more percentage points.

Note as well that if your investments earn more than 8%, your pre-tax equivalent return will be higher as well. For example, at the 35% tax rate, the 8% return is equivalent to a 12.3% pre-tax return. Increase the 8% return to 10% and your pre-tax equivalent return increases from 12.3% to 15.4% (10% return divided by .65). That represents an additional 3.1 percentage points on top of the 12.3% rate.

To further illustrate the value of making voluntary contributions, here is the total payoff if you annually invest an additional $2,000 per year into your retirement account (we assume the $2,000 IRA contribution is made at the end of the year).

# of Years                      Total Value at End
of $2K          Sum of the      of Term at 8%
Contributions   Contributions   Annually

10              $20,000         $28,973
20              $30,000         $54,304
30              $40,000         $91,524
40              $50,000         $146,212

Just as with tax-deductible retirement plan contributions, non-deductible contributions compound tax-free every year the money remains in your account. That's why they should be a significant part of your retirement planning.

The long answer? Well, there may be some situations where your excess cash could be better used by paying off high-interest debt, such as credit card debt. Talk to your financial advisor. But always remember: monies held in retirement accounts cannot be seized by creditors, even in bankruptcy. This is especially valuable to people, such as business owners, that take and bare risk.

COPYRIGHT 2012 D.L. Perkins, LLC
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 2012 Gale, Cengage Learning. All rights reserved.

Article Details
Printer friendly Cite/link Email Feedback
Title Annotation:RETIREMENT
Publication:The Business Owner
Article Type:Column
Geographic Code:4EUUK
Date:Jul 1, 2012
Previous Article:Control and minority stakes.
Next Article:Lower your tax rate.

Terms of use | Copyright © 2018 Farlex, Inc. | Feedback | For webmasters