Tax-Sheltered Investment Accounts: Fund Yours Now, Retire Later

Taxes are a huge drain on your wealth. Each time you earn income or realize a gain on an investment, you pay Uncle Sam. One of the only ways to plug the hole is to get investments into tax-sheltered accounts - retirement savings accounts such as an IRA or 401(k). Investments in these accounts accumulate tax-free! The cumulative benefit is substantial. To illustrate, the first table below shows tax-free equivalent annual rates of return. If your investments are in a tax-free account, and your regular overall state and federal tax rate is 35%, you actually earn the equivalent of 12.3% in your tax-sheltered account (an additional 54%!).

Over time, the impact of this additional rate of return - coupled with the pretax contribution allowance - can be substantial. Let's assume that Sam puts $5,000 of his income (after tax) each year into a regular investment account and earns, on average, 8% per year. Julie forgoes the same annual after-tax amount of salary, but because she is taking advantage of a salary reduction option in a retirement saving plan (and therefore the dollars go into her account pretax), her $5,000 after-tax commitment equals $7,692 on a pretax basis, given that she is in the 35% overall income tax bracket. She also earns 8%, but investment returns in her account compound tax-free. The table below shows the difference in the account balances of Sam and Julie at 10, 20 and 30 years.

Julie has done little more than take advantage of basic retirement planning options offered by the IRS and used by millions of people, but her savings is substantially higher.

It is important to note that the money in Sam's account is tax paid, so he will owe no tax on his funds upon withdrawal. Julie's money will be taxed upon withdrawal at her ordinary income rate, but we have adjusted her account balance in the table above to show the after- tax value, assuming an overall tax rate of 35%. Julie's actual account balance after 30 years is $1.064 million. The after-tax amount is the $692,000 value used in the table.