P—Tax-Favored Retirement Plans

Tax-favored retirement plans can be established in a variety of ways.

• Qualified retirement plans such as defined benefit pension plans, money-purchase pension plans, and 401(k) plans, can be installed in a corporation, a partnership or a sole proprietorship.
• Individual retirement arrangements (IRAs), including both individual retirement accounts and individual retirement annuities, can be established by many taxpayers. With a simplified employee pension plan (SEP) or a SIMPLE IRA, employer contributions can also be made to individual retirement accounts.
• Section 403(b) plans are available to employees of public schools and colleges, and certain non-profit hospitals, charitable, religious, scientific and educational organizations.
• Section 457 plans are available to employees of state and local governments and tax-exempt organizations.

To better appreciate the advantages of tax-favored retirement plans, we can compare the growth of a tax-favored account to the results obtained when after-tax funds are invested outside a tax-favored plan . . . for example, in certificates of deposit, savings accounts, or treasury bills. Assume that there are $1,000 of before-tax funds available for investment per year over the next 20 years.

Taxable Growth. If after-tax dollars were invested outside of a tax-favored plan, assuming a 25 percent tax bracket, of the original $1,000 only $750 per year would remain after-taxes for investment. The earnings will also be taxed, which means that although the investment might pay 8 percent interest, it would yield only 6 percent after-taxes. The reduced after-tax funds available for investment, combined with the reduced after-tax yield, means that in 10 years $10,478 will have accumulated, and in 20 years $29,245.

Tax-Deferred Growth. The tax leverage provided by a tax-favored plan offers the opportunity for substantially increased accumulations, because there are no current taxes on contributions, and no current taxes on investment earnings. This means that each year $1,000 will actually be invested, and a full 8 percent rate of return will actually be credited, neither being subject to current income taxation. A tax-deferred growth of 8 percent will accumulate $15,645 in 10 years, and $49,423 in 20 years. Although payments received during retirement will be taxable, after-tax income will usually far exceed that available with investments that are not tax-favored.