In a post back in March of this year (shown at the link below), I developed a very useable spreadsheet for everyone to use in calculating how much they should save for retirement each year.
However, one thing I left out of this post was demonstrating how powerful (and just how much money you can save) by being able to invest money in your 401k or Traditional Roth IRA account pre-tax. Therefore, this will be the subject of today’s post.
In my opinion, the best way to demonstrate the potential savings is with an example.
Let’s say that a 30 year old woman named Shantel makes $75,000 per year in gross income. She has been putting off saving for retirement for a very long time, but finally, she has committed to herself that this year will be the year. And, she wants to save $10,000 towards her retirment goal of $1,000,000. Clearly, she has quite an aggressive goal!
So, we know what Shantel wants to accomplish. Let’s first take a look at what her take-home income would be, assuming that she does not contribute anything towards her retirement goal and she has a tax rate of 28%.
$75,000 x (1-28%) = $54,000 take home pay
Now, let’s take a look at what her take home pay would be if she decides to contribute $10,000 towards her retirement account.
$75,000 – $10,000 401k contribution = $65,000 x (1-28%) = $46,800 take home pay
Difference in take home pay = $7,200 (28% less than $10,000 saved for retirement)
In this example, you can clearly see the POWER of paying yourself first (before the government takes ahold of the money through taxes). In fact, you end up allowing yourself to come out $2,800 ahead!
Now, let’s see what happens when you spread this advantage out over the number of years Shantel has until retirement at age 65.
In one scenario, we will assume that Shantel saves $7,200 per year after tax towards her retirement. In the other scenario, we will assume that Shantel saves $10,000 per year pre-tax (since it doesn’t cost her any more purchasing power to do this). In both cases, we will assume that she invests the funds at a rate of return of 10%.
The results of can be seen in the Google Docs spreadsheet at the link below.
Google Docs – Shantel’s Quest to Become a Millionaire
What we see is that by investing pre-tax, Shantel is able to become a millionaire 3 years quicker than she would if she were to invest her funds after-tax.
Even more impressive is that fact that at age 65, by investing pre-tax, she is able to accumulate close to $800,000 more for retirement. Quite an impressive sum!
So, I hope this article has given you some added perspective, and perhaps incentive, for doing your best to take advantage of your tax-sheltered savings accounts. This pre-tax contribution idea is especially important for those of us shooting for early retirement.
As always, please let me know if you have any questions.
Keep on learning!
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