Believe it or not, we are currently in one of the lowest tax environment’s in the history of the US government. At one point in history, the highest marginal tax rate in the United States was 94%. Now is the time to take advantage of the various tax free savings accounts for several reasons.
There are two main types of tax advantaged accounts available to investors, pre-tax and after-tax accounts. Governments are free to add or remove these types of accounts at any point they deem necessary, so it’s important to use tax free savings accounts to your advantage. As your income progresses, these tax savings will become more beneficial. Since your last dollar of income is taxed at your marginal rate, you will receive the most benefit by contributing to a tax advantaged retirement account.
Pre-tax accounts include things like a 401k and a traditional IRA. These accounts typically allow you to contribute on a pre-tax basis, reducing your AGI(adjusted gross income). The benefits of these accounts are that it allows you to instantly reduce your income and this money will compound over time. Reducing your income will have you paying less in taxes and the higher bracket you’re in the more you’ll save. Compounding may be one of the most powerful financial terms around and since you’re contributing on a pre-tax basis, you have more money that will be allowed to grow and you’ll only have to pay taxes upon withdrawal.
After tax accounts like a Roth IRA don’t offer the up-front tax savings of a 401k but they do allow you to withdraw your money tax free in retirement. With this option, you are effectively locking in a certain tax rate now so that you may withdraw tax free later on in retirement. This is one of my favorite options since taxes are low and I think there is only one direction they can go in the future, up.
Both types of accounts have their pros and cons, but a smart investor will usually diversify between both types of accounts. We don’t know for sure where tax rates are headed, but it’s good to be prepared for any scenario.