The tax benefits of your retirement savings plan –Part 1

Taxes can take a big bite out of your total investment returns, so it's encouraging to know that your employer-sponsored retirement savings plan may offer a variety of tax benefits. Depending on the type of plan your employer offers, you may be able to benefit from current tax savings; tax deferral on any investment returns you earn on the road to retirement; and possibly even tax-free income in retirement.

Lower your taxes now

When you contribute to a traditional retirement savings plan, such as a 401(k) or 403(b), your plan contributions are deducted from your pay before income taxes are assessed. These "pretax contributions" reduce your current taxable income, which in turn reduces the amount of income tax you pay to Uncle Sam each year that you participate. Consider the following example, which compares two different employees.

Let's assume Employee 1 gets paid every two weeks, with gross pay of $2,000 and a 25% federal tax rate. In this case, Employee 1 would pay about $500 in taxes each pay period. Now let's assume Employee 2, who earns the same gross pay and has the same tax rate, contributes 6% of his salary each year to a retirement savings plan. In this instance, his gross pay would be reduced by $120 each pay period, resulting in a taxable income of $1,880. In this case, taxes would be $470 - or $30 less than the previous scenario. So Employee 2 would have invested $120 in a retirement savings plan and saved $30 in current income taxes.

Keep in mind that this example is hypothetical and has been simplified for illustrative purposes only. Your actual situation will differ. Withdrawals would be taxed at then-current rates. Early withdrawals prior to age 59½ will be subject to a 10% penalty tax, unless an exception applies.

Tax-deferred growth potential

Tax deferral is the process of delaying (but not necessarily eliminating) the payment of income taxes on returns you earn. Whereas in taxable investment accounts, you would have to pay taxes on your earnings - even if you reinvest them - in a tax-deferred account, you can delay paying taxes on your returns until you withdraw money. For example, the money you put into your employer-sponsored retirement account isn't taxed until you withdraw it, which might be 30 or 40 years down the road!

Tax deferral can be beneficial because:

• The money you would have spent on taxes remains invested

• You may be in a lower tax bracket when you make withdrawals from your accounts (for example, when you're retired), and

• You can potentially accumulate more dollars in your accounts due to compounding

Compounding means that your earnings become part of your investment dollars, and they in turn can potentially earn returns. In the early years of an investment, the benefit of compounding may not be that significant. But as the years go by, the long-term boost to your total return can be dramatic.

Keep in mind that returns cannot be guaranteed. Your investments will fluctuate through the years. Also, withdrawals prior to age 59½ will be subject to a 10% penalty tax in addition to regular income taxes unless an exception applies.

Continued in Part 2 in the next issue of The Loop.

Article courtesy of Forefield. Securities offered through NPB Financial Group, LLC. A Registered Investment Advisor/Broker-Dealer Member FINRA, MSRB, and SIPC