The tax benefits of your retirement savings plan – Part 2

Tax deferred is not the same as tax free. "Tax free" means that no income taxes are due at all. Some employer-sponsored savings plans, like Roth 401(k)s, Roth 403(b)s, and Roth 457s, can generate tax-free income during retirement. When you contribute to a Roth account, you don't receive a current tax benefit like you would with a traditional pretax savings account, but your earnings can still grow without having to pay taxes on them each year. Then, qualified withdrawals are tax free. (Nonqualified withdrawals are subject to regular income and penalty taxes.) In general, a withdrawal from a Roth account is qualified if it satisfies both of the following requirements:

• It's made after the end of a five-year waiting period

• The payment is made after you turn 59½, become disabled, or die

Taxes make a big difference

Let's assume two people have $5,000 to invest every year for a period of 30 years. One person invests in a tax-free account like a Roth 401(k) that earns 6% per year, and the other person invests in a taxable account (an investment account outside his or her retirement plan) that also earns 6% each year. Assuming a tax rate of 28%, in 30 years the tax-free account will be worth $395,291, while the taxable account will be worth $295,896. That's a difference of $99,395.

This hypothetical example is for illustrative purposes only, and its results are not representative of any specific investment or mix of investments. Actual results will vary. The taxable account balance assumes that earnings are taxed as ordinary income and does not reflect possible lower maximum tax rates on capital gains and dividends, as well as the tax treatment of investment losses, which would make the taxable investment return more favorable, thereby reducing the difference in performance between the accounts shown. Investment fees and expenses have not been deducted. If they had been, the results would have been lower. You should consider your personal investment horizon and income tax brackets, both current and anticipated, when making an investment decision as these may further impact the results of the comparison. This illustration assumes a fixed annual rate of return; the rate of return on your actual investment portfolio will be different, and will vary over time, according to actual market performance. This is particularly true for long-term investments. It is important to note that investments offering the potential for higher rates of return also involve a higher degree of risk to principal.

How much can I contribute?

Individuals can contribute up to $18,500 (in 2018, $18,000 in 2017) to a 401(k), 403(b), or 457 plan. The limit increases to $24,500 (in 2018, $24,000 in 2017) for those age 50 or older.

If your plan offers a Roth option, you can split your contributions between the traditional and Roth plans, but the total amount cannot exceed these limits. Be sure to check your plan's documents as some plans may impose lower limits.

Even if you cannot contribute the maximum amount, be sure to contribute what you can. Through the power of compounding, even small amounts have the potential to add up over time. Then, try to increase your contribution whenever possible - for example, as you receive raises or pay off debts.

A word about employer contributions

Your employer may also contribute to your plan account through matching or profit-sharing contributions. These contributions also benefit from tax deferral. In other words, you do not have to pay taxes on employer contributions or their earnings until you withdraw them. If your employer offers a matching contribution, try to contribute enough to receive the full amount. Employer matches are free money so try to take full advantage of them!

Bottom line

Though tax considerations shouldn't be your only concern when investing for retirement, it's a plus to know that participating in your employer-sponsored plan can help you keep more money in your own pocket and put less in Uncle Sam's.

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