4th Step to Financial Freedom – Contribute Maximally to Your Tax-Favored Retirement Accounts

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The benefits of tax-favored retirement plans like the Thrift Savings Plan or an Individual Retirement Account (IRA) are too great to ignore, and over the span of your career sheltering your investment earnings from the taxman will benefit you tremendously.  For example, assume that you make a $4,000 annual contribution for 45 years and earn an 8% annual return.  Here is how much you would have if you invested in a taxable investment account versus a tax-deferred account:

  • Taxable investment total – $604,407
  • Tax-deferred investment total – $1,669,670

As you can see, the power of keeping your investment returns and not paying taxes on them can lead to huge differences in the amount of investment growth you will experience.

The primary tax-favored investment account that is available to us is the Thrift Savings Plan (TSP).  If possible, you should always contribute the maximum amount each year, which is $18,000/year in 2015 and 2016 ($24,000/year if you are over 50).  You may be able to contribute more if you are deployed in a combat zone.  See this TSP Annual Limit on Elective Deferrals PDF to read about the details.

After you fill your TSP, open an IRA and, again, contribute the maximum amount each year.  The contribution limits for 2015 and 2016 are $5,500/year ($6,500/year if you are over 50).

For both the TSP and IRA you’ll face the decision of whether to contribute to a Roth or traditional version.  Roth contributions are taxed now, meaning you make after tax contributions and future withdrawals are tax free.  Traditional contributions are taxed when you withdraw, meaning you make pre-tax contributions now and pay taxes later.  For younger or military people, the Roth is usually more advantageous because your tax rate is lower than it will be in the future, but there are many on-line calculators to help you decide which option is best for you, including:

https://www.tsp.gov/PlanningTools/Calculators/contributionComparison.html

http://www.bankrate.com/calculators/retirement/roth-traditional-ira-calculator.aspx

Here is a great comparison chart from Vanguard:

https://investor.vanguard.com/ira/roth-vs-traditional-ira

The Roth IRA does require an adjusted gross income of less than $117,000/year (single) or $184,000/year (married) in 2016 to fully contribute, but there is a way around this called a “backdoor” Roth IRA.  For a tutorial on how to do this, go to:

http://whitecoatinvestor.com/backdoor-roth-ira-tutorial/

If you moonlight as an independent contractor (you’ll know because you will be paid with a Form 1099), you will have other tax-favored options available to you, including a SEP-IRA or Solo 401k.  In these accounts you can often contribute a lot more money.  For a full discussion of them see:

http://whitecoatinvestor.com/sep-ira-vs-solo-401k/

The bottom line is that to maximize your net worth you need to maximize your contributions to all tax-favored retirement accounts you have available to you.  Hiding your investment earnings from the taxman will allow you to accumulate a lot more for retirement.

 

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