IRA Financial’s Adam Bergman discusses tax deferral and capital gains, the differences between the two and why they matter when it comes to retirement savings.
In this Podcast
Why save in a retirement account? Isn’t capital gains better for me? The simple answer is tax deferral and compound interest. Albert Einstein said it best: “Compounding interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.” Warren Buffet is another investor who preaches the power of tax deferral and compounding interest.
What is tax deferral? Everything you invest in outside of a retirement plan is subject to tax. Every year, your investments grow (hopefully). You must pay taxes on the earnings and income generated. For example, if you have a rental property. That income is taxable. However, if you had the same property, you don’t pay taxes on the income annually. Instead, the taxes are deferred until you start withdrawing during retirement. The benefit there is that you’re generally in a lower tax bracket when you retire. Imaging having a job making $75,000 per year. Add in $15,000 of rental income. Now, you pay taxes on $90,000, which increases your tax bill. Every year. With a retirement plan, you don’t have to withdrawn that rental income until you are at least age 72. Of course, you may choose to withdraw earlier if you so choose.
Further, compounding interest makes your investments work more for you. Imagine your portfolio is comprised of only stocks. On average, you may see a seven to ten percent return on them. When held inside an IRA or 401(k) plan, as your plan balance increases, so does your returns. For example, if you had $10,000 in your plan and you earn 10% in year one, it’s now worth $11,000. Because of compounding interest, that same 10% will generate $1,100, since it was not taxed. After year two, you will have $12,100. In year three, you will earn $1,210. Imagine doing that for thirty or forty years!
If you had a starting balance of $10,000 at age 30 and never contributed another nickel to the plan, and you earn 10% every year, your balance would be over $280,000 by age 65. If you only earned 5%, your balance would be $55,000. One more example to show you how tax deferral and compounding interest is enormous: Let’s say you are 25 years old just starting out. You contribute just $100 every month until you reach age 65 and see a 7% return annually. By age 65, your plan would be worth almost a quarter of a million dollars.
Obviously, there’s a lot of factors in determine how well your plan will grow. Your age, how much you contribute and how well your investments perform are all factors. Any way you shake it, it’s much better to invest inside a retirement plan, than outside!
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Join us next episode as Mr. Bergman discusses Roth IRA conversions – how to do them, why you should and the benefits of the Roth.