Retirement Accounts: Should You Fear the Eventual Tax Bill?

From Women & Co. by Jonathan Clements, Director of Financial Education, Citi Personal Wealth Management for the HuffPo writes:   Some people are reluctant to fund Individual Retirement Accounts and 401(k) plans, fearing they are setting themselves up for big tax bills in retirement. After all, retirement-account withdrawals are typically taxed as ordinary income, which can mean paying a federal rate as high as 39.6 percent in 2013. By contrast, in a taxable account, any qualifying dividends and long-term capital gains are taxed at a maximum federal rate of 20 percent.

What to do? If you're eligible, you can always fund a Roth IRA or Roth 401(k) instead. Roth accounts don't offer an initial tax deduction, but withdrawals can be federal and state tax-free if you follow the rules. But even if the Roth isn't an option, a tax-deductible IRA or 401(k) remains a fine choice. That's because the initial tax deduction often pays for the eventual tax bill.

To understand why, consider a simple example. Suppose you are in the 25 percent federal income-tax bracket today -- and you're still in the 25 percent bracket once you retire. If you put $1,000 in a tax-deductible IRA, your out-of-pocket cost would be $750, thanks to the $250 tax savings.

By the time you retire, let's assume your IRA has grown a hypothetical 100 percent to $2,000 (though there are, of course, no guarantees). At that juncture, you cash out the account, paying 25 percent to the government. That leaves you with $1,500, or 100 percent more than your $750 investment. In effect, the IRA gave you tax-free growth on your initial $750 out-of-pocket cost.

To be sure, if you are in a higher tax bracket in retirement, you won't enjoy totally tax-free growth. On the other hand, if your tax bracket falls in retirement -- which often happens -- you will benefit at Uncle Sam's expense.

Women & Co., a service of Citi, is the go-to personal finance source for women. By providing financial content, commentary and community, Women & Co.'s mission is to get women thinking and talking about personal finance. Founded in 2000, Women & Co. is one of the longest running personal finance websites dedicated to helping women strengthen their financial futures.