Personal Finance

One key to building wealth is “Don’t turn down free money!”  When you maximize contributions to your qualified retirement plans you accept free money from three sources:

1)      The taxes you normally owe the government,

2)      The interest earned on the government’s tax dollars which are now inside your retirement plan and

3)      The interest earned on the interest.

By maximizing your pre-tax contributions you accept the government’s “free” money, build wealth faster and are able to retire sooner.

Let’s assume you are married with a household income of $48,000/year, and you are my neighbor in Colorado.  Let’s also assume you are contributing 6.25% of your salary or $3,000 annually to your 401(k) plan.  Should you increase your contribution by $1,800/year to get to the lifelong minimum savings rate of 10%?

If you are in the 15% federal tax bracket, you are paying an unnecessary $350 in federal and state taxes, by not contributing the additional $1,800.  In other words, Uncle Sam and the State of Colorado will reduce your taxes by $350 if you will put an additional $1,800 into your retirement plan.  That’s an instant 19.4% return on your savings.

In reality you are only putting $1,450 of your own money into your retirement plan because the additional $350 is the taxes you would have to pay Uncle Sam and the state if you did not defer your income.  Sometimes, I call this $350 in deferred taxes the “government match”.  It’s as if our government is paying you $350 to motivate you to save $1,450 of your own money.  Isn’t this a great country?

In the table below we have calculated the value of this “free money” ($350/year tax savings) invested in a conservative portfolio of stocks and bonds* over 1-, 10- and 20- year time periods.  The table assumes you remain in the same tax bracket every year.

(*) Annual return 8%, average fund operating expenses 0.3%.

There’s an additional bonus.  Money in qualified retirement plans is protected from creditors by federal law (ERISA).  Even though OJ Simpson was convicted of murder in civil court, the judge could not use OJ’s NFL pension money to pay the monetary damages he awarded to the victims’ families.  Is it any wonder that many experts call Qualified Retirement Plans the “World’s Best Tax Shelter”?  Maximizing contributions to your qualified retirement plans is the fastest way to build wealth that can’t be taken from you by creditors.

Check your own “free money” numbers at:  http://www.peoplesfinancialadvisor.com/financial_checkup.php