- Pay taxes now - These are traditional savings accounts and stock and bond investments. A bank pays me interest each year and I pay taxes on it immediately. If the stock pays a dividend, I am taxed. And when I sell the stock or bond I have to pay taxes on what I earned. I have prepared taxes for folks for several years, and these always cause the most disappointment. They come in with a big smile on their face with their statements from their investment firm, to show me how much they made on the stock market this year. I then have to tell then that they now I taxes as regular income at their normal withholding rate. What this means is that they not only have to pay taxes on the earnings, the income could push them into a higher tax bracket causing them to pay even more tax. The advantage is that the cash is easily available which is where I would want to keep my emergency fund.
The trouble with this method is that when I pay taxes as I go along, I never get ahead. For instance, consider starting with one dollar and double it every year for 20 years without paying taxes. How much would you have? The answer is over one million dollars! But take that same dollar and double it each year and pay taxes as you earn it. What would I have then? About $27,000 assuming a 30% income tax rate. Enter the pretax savings plans.
- Pay taxes later with tax free growth - 401k, 403b and IRA all let me deduct money from my paycheck before taxes are deducted. The money is placed into a fund managed by someone like Vanguard or Fidelity, who offer a number of mutual funds for growth. Also, when, or if, the money grows, the income isn't taxed until I take it out. Money taken from my pay is usually based on a percentage of my total pay. Also a few of my employers gave me a match up to a certain limit. For instance, if I were to save 5% of my paycheck, the employer will give me another 2 to 5%. It all depends on the employer and how generous they want to be. I like free money. This method is better because I can take advantage of growth without paying taxes, as I mentioned earlier. There are no free lunches, though, because I will have to pay taxes on the money as I withdraw it. And no matter how you may feel about taxes, one thing is certain. Taxes will increase. Our national debt has to be paid and we have to pay it someday.
For example, if I need to have $50,000 cash to live on each year, and my only source of income is from my pre-tax account, I will have to withdraw at least $70,000 to cover both what you need and what Uncle Sam wants.
- Never pay taxes with after tax money and tax free growth - The Roth IRA lets me take money from my payroll after I have paid taxes on it and invest it. The growth is tax-free while it grows, and, if I keep it the required number of years, I can take out the earnings tax-free as well. Unfortunately, for most of us, we can only put $5,000 per year or $6,000, if I am over 50. Not quite enough money for a big nest egg, but a good start.
What I want, though, is something I can invest it, not pay taxes as it grows, not pay taxes when I spend it and have something left to take care of my family when I die. And maybe, if I am a good planner, I could even use it for part of my retirement money.
Other than the pay now tax now savings accounts, all the other methods are for a long term plan. I should not put my money in with the expectation of taking it out until retirement.
After all, what I want, when I retire, is the ability to continue getting a paycheck. I don't want some huge windfall of cash because I would still need to put it somewhere safe so I can take it out as I need it. Given that, there are two ways I can invest my money into something that will protect my money from the falls in the market, give a death benefit to my wife, grow, and give me a tax advantage with the growth. For me, at my age, I would invest in annuities. For someone younger, say in their 20's, they would want to give serious consideration to a permanent life insurance policy.
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