As you might guess, I filed my taxes this weekend. I also have had some big life changes. I am no longer funemployed! My job was supposed to start today but we are having a good old fashioned snow day instead! Kind of a bummer, but now I get to tell you about some of the things that I just learned about taxes.
Along with my new job comes some new benefits. I had to decide on my benefits this weekend, too, so I now have many more thoughts about that.
The first thing I learned was a little bit about how to work the tax system (thanks, Mom!). You know how I told you all that 401k’s are tax deferred? Meaning, you pay taxes on them when you are ready to retire, but you don’t pay taxes on the money now? Here are a few new things that I just learned.
- You pay taxes on the amount in your retirement not based on the amount of money you made the last year you worked (ideally, this will be a gazillion dollars) but on the amount of money you take out of your retirement each year when you are retired (ideally, this will not be a gazillion dollars). Therefore, you will pay taxes during retirement based on the tax bracket of someone with your “retirement income.” Which may or may not be lower than your income is now, but you have control over how much you take out, and therefore you can control which tax bracket you are in when you retire.
- You can LOOK UP tax brackets and do the calculations yourself. This may sound like the most obvious thing in the world to some of you, but taxes have always been a big mystery to me and I didn’t realize it can be simple to estimate your taxes. I’m really smart, I swear! I just don’t like taxes.
- Because you don’t pay income tax on tax-deferred savings, you are able to put more money into your investments at the start (and you can look up how much more, depending on your tax bracket). This means more money (like, 25-30% more…not insignificant) will be subjected to compound interest from the get-go. So your end result will be much higher than if you had paid taxes on the same amount at the beginning (like for a Roth IRA). Don’t forget that you have to pay taxes when you withdraw your funds, though. There is no escaping Uncle Sam, but you can decide how and when you want to pay those taxes.
- When you put money into tax deferred accounts, you can actually calculate the amount of money you will be saving in taxes, so it is a little easier to choose how much to save. For example:
Say I make $80,000 per year. I am able to invest up to 5% into my 401k ($4000). Not only am I getting compound interest (like a boss), but I also am spending less on taxes! Here is the math (based on the 2014 tax schedule):
|Taxable income||Amount invested||Amount owed in taxes||Difference from no investment||Summary|
|Without investing in 401k||$80,000||$-||$15,856||n/a||$0 invested, $0 tax savings|
|Investing 2.5% in 401k||$78,000||$2,000||$15,356||$500||$2k invested, $500 tax savings|
|Investing 5% in 401k||$76,000||$4,000||$14,856||$1,000||$4k invested, $1k tax savings|
It is a bit of a balancing act: if you put more into your 401k, you have less cash to spend today, but you also save on taxes (which you can spend before you retire). If you can afford to contribute the maximum into your 401k, you get compound interest, but you also pay less in taxes.
Hopefully this was obvious to all of you, but I had not thought of tax deferred investments as a tool to decrease your tax load (probably because I have never had benefits before….), but there you are- an added benefit to saving for retirement!