Do IRA and 401(k) Contributions Still Make Sense?

As a result of The 2003 Tax Relief Act the maximum income tax rate is now 35% and long-term capital gains (realized after May 5, 2003) and qualifying dividends are taxed at a top rate of 15%. With these lower rates, many question whether it still makes sense to participate in their 401(k) plans or make contributions to their IRAs.

In almost every case, the answer is a resounding YES. Planning for a financially secure retirement is most often ranked as the number one reason why people save and invest. Social Security and company pension plans may provide some of the income you need during retirement, but contributions to your company retirement plan and your IRA may make the difference between enjoying the retirement lifestyle you want or relying on others for your basic needs.

Contributions to retirement plans and IRAs move you closer to a financially secure retirement in three ways:

You save and accumulate money. Having a portion of your wages deferred into your 401(k) or other retirement plan can be the simplest and least “painful” way to save. Often the amounts are not missed as you automatically adjust your spending accordingly. Contributions to an IRA also add up, especially over longer periods of time. Contributing $5000 a year over 20 years will add up to almost $184,000 with a 6% earnings rate.

Your earnings are tax deferred. Earnings on funds within your retirement plan and IRA are not subject to income tax each year the way your other savings are. This means you have more money working for you. You will have to pay tax on the earnings when you withdraw the funds (except for a Roth IRA), but most people are in lower tax brackets when they retire.

You reduce your current income taxes. The amount you defer into your 401(k) plan reduces your taxable wages and you pay less tax each year. For 2009, the limit on the amount you can tax-defer into your 401(k) is $16,500 unless you were age 50 or above and then it is even larger. Contributions to a regular IRA for 2009 are deductible if you are not covered by an employer-sponsored plan or if your adjusted gross income is below $89,000 (married filing jointly) or $55,000 (filing a single tax return). Contributions to a Roth IRA are not tax deductible, but distributions are tax-free.

Saving for retirement in 401(k) plans and IRAs continues to make good financial sense. While the 2003 Tax Act reduced the tax rates, the benefits of tax deferral and the potential for reducing current taxes should not be ignored.