The IRA (Individual Retirement Account) is the most common taxed-deferred savings plan in the United States. Earned income deposited into an IRA is not taxed in the current year, and no taxes are incurred on the interest paid in subsequent years. However, when you withdraw the money from the account after age 59 ½, you pay taxes on the entire amount that is withdrawn.
Suppose you deposit $ 4000 of earned income into an IRA account, you can earn an annual interest rate of 2% (assume the money is compounded annually), and you are in a 40% tax bracket (which means 40% of earned income is paid in taxes and you get 60%). (Note: We recognize that the interest rates and tax brackets are subject to change over a long period of time, but some assumptions must be made to evaluate the investment.)
To provide a timeframe, suppose you deposit the $ 4000 at age 25 and withdraw it at age 68?
Using the above information about the IRA account, How much money will be in the account at age 68? How much will remain after you pay the taxes at age 68?
Alternative Option#1: Suppose that instead of depositing the money into an IRA, you pay taxes on the money first (when it is initially earned) and the annual interest each year. How much money will you have at age 68? [Note: To consider this scenario you can think of it this way…..You effectively start with $ 2400 (60% of $ 4000), and the money earns 1.2 % (60 % of 2%) interest each year after taxes.]
Alternative Option #2: Suppose you pay taxes on the original $ 4000, but are then able to earn 2% in a tax-free investment. Compare your balance at age 68 with the other options.
As a final consideration, what if you would leave the money in the account an additional 5 years, so, in other words, you choose not to withdraw it until you are 73. How much difference in amounts will it make? Is it worth it?
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