Saving for your retirement is a good thing and if you can save taxes at the same time this is an added bonus. Everyone agrees the less you pay Uncle Sam the more you can save for your future.

Tax deferred accounts were established to encourage people to save for retirement, and the main attraction is the tax deduction for the amount contributed. If you defer part of your salary into your employer's retirement plan such as 401k, the deferred amount is not reported as taxable income. Traditional IRA contributions may also be deductible depending on your income and participation in an employer retirement plan. Additionally, any income or capital gains generated on investments inside the 401k or IRA are not taxed annually.

Retirement plan contributions can generate substantial tax savings. If you contribute $20,000 to a 401k plan and are in the 25 percent tax bracket, you save $5,000 in federal income taxes. This $5,000 can stay invested and grow for your retirement. Making the maximum allowed annual retirement plan contributions seems highly advisable, so what is the down side?

When it comes to retirement accounts, you pay later for all the savings you get now. When you withdraw your retirement funds down the road, all of your deductible contributions plus the earnings and growth on your investments are taxed as ordinary income. Starting at age 70 ' you are required to take minimum distributions and your heirs will pay income tax on any withdrawals they make from inherited accounts.

Jim and Sally both contributed faithfully to their employer retirement plans annually during their working years. When they retired at age 65, they wanted $75,000 annually to supplement their Social Security income. Because the withdrawals are taxable and they were in the 25 percent tax bracket, they had to withdraw $100,000 to have $75,000 to spend after taxes. The extra $25,000 expense was something they hadn't planned on and was a substantial cost to access their savings.

You can avoid this problem by saving in taxable accounts in addition to tax-deferred accounts. Consider saving an equal amount or more in a regular brokerage account such as a joint account or living trust. You won't be able to deduct the savings and any taxable income or capital gains will be reported annually; however, your taxable investment accounts can be managed to minimize taxes.

The current capital gains rate is 15 percent, and qualified dividends are also taxed at 15 percent. Additionally, in a year such as 2008 when most investors incurred losses, you are allowed to harvest your losses and take a deduction for the current and future tax years.

The benefit of having access to non-retirement account funds becomes evident when you need money to support your retirement spending. If Jim and Sally had been able to access $75,000 in a taxable investment account each year for the first five years of retirement, they could have avoided paying $125,000 in income taxes and allowed their tax-deferred retirement accounts to grow during this period. They would have some taxable income to report annually on the taxable portfolio but substantially less than having to report all the withdrawals from their IRAs as ordinary income.

Employers make it easy to defer your salary into their retirement plans. However, this doesn't mean that is all you should do to save and prepare for retirement. Most retirees will need to accumulate much more than can be contributed to an annual IRA and/or 401k account. For 2009, the maximum amount you can defer into a 401k is $15,000 and the maximum traditional IRA contribution is $5,000 if under age 50. The amounts established for the tax law are arbitrary and have no relationship to your retirement goals or needs.

Additionally, any funds you are saving for your kids' college or buying a new home should not be saved in a retirement plan. With limited exceptions, funds withdrawn from IRAs and other retirement accounts before you are 59 -- will be accessed an additional 10 percent tax penalty.

As with everything in life, investing is a balancing act. Balance your savings between tax-deferred and taxable accounts for the best long-term results and lowest overall payments to Uncle Sam.

 

Connie Brezik is a Casper investment advisor and financial planner. Her email is connie@asset-strategies-inc.com.