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.
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|Publication:||The Business Owner|
|Date:||Jul 1, 2012|
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