By investing money through an IRA, you can claim a tax deduction on your contribution. You won’t pay any taxes on the interest your contribution earns each year. Instead, when you take your money out after age 59 1/2, you will pay tax on your contributions and the interest.*
This tax deduction, and the fact that you owe no taxes on your investments during the many years you are saving, will have a major impact on how large your retirement nest egg will be.
What are the tax advantages of investing your retirement contributions through an IRA? Let’s say you invested $5,000 a year for 20 years and your money earned 8% per year. How much money would you have after 20 years if you invested the money outside an IRA versus inside an IRA?
Outside an IRA: You will owe taxes on your $5,000 contribution each year. If your tax bracket is 28%, at the end of 20 years you will end up with $129,062 after taxes.
Inside an IRA: You will get a tax deduction of $5,000 each year and at the end of 20 years you will have $164,743 (after paying taxes in the 28% tax bracket).
Conclusion: You earned 28% more after taxes simply by putting your money in an IRA account!
Therefore, to maximize your retirement savings, you should take full advantage of the different IRA options available to you and put as much of your retirement investments as possible into IRAs.
I will discuss these different IRA options in future articles.
* The Roth IRA is an exception to these rules. You won’t get a tax deduction for a contribution to a Roth IRA. When you take your money out, you won’t owe tax on your contributions or the interest earned.
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For more information see my book Family Child Care Money Management and Retirement Guide.