Why choose a Freedom Account account in addition to your employer’s 401(k) or 403(b) plan, when you can get a deduction for contributions to a traditional account? The simplest reason is that the tax rules allow you to build a Freedom Account just as large as a traditional account, and when you retire, the Freedom Account will be more valuable.
The contribution limits for your Freedom Account are limited only by your needs and your budget. You also have different investment opportunities for both types of accounts. That means you can build a Freedom Account to the same size as a traditional account.
Nevertheless, the Freedom Account is more valuable. Distributions from a traditional account are taxable, while distributions from the Freedom Account are not. The difference can be surprisingly large. For example, if you’re in the 25% tax bracket, you have to withdraw $133.33 from a traditional account to have $100 in spending power, because $33.33 will be used to pay tax on the distribution.
Here’s a chart showing the amount you would need in a traditional account to have the equivalent of $100 in a Freedom Account, for each of the current tax brackets.
Saving in a Freedom Account can make you as much as 65% wealthier in retirement! When you take state income taxes into account, the difference can be even greater.
Paying Taxes in Retirement
Unless you’re close to retirement and have a good handle on what your income and deductions will be, it’s hard to even guess what your tax bracket will be. If you’re guessing it will be on the low side, be sure you aren’t overlooking the following:
• More and more people work at least part time during “retirement,” either to help make ends meet or simply to keep active.
• Up to 85% of your social security benefits can be taxable.
• With a sound investment approach, your retirement account should grow substantially over the years, and that will mean large withdrawals when you begin taking the money out. If the money is in a traditional account, these withdrawals will boost your income and possibly put you in a higher tax bracket than you might otherwise expect.
• Various budget realities, including huge costs associated with the aging and retirement of the baby boom generation, make it difficult for the federal government to achieve lasting reductions in tax rates.
So traditional retirement accounts always lose?
This doesn’t mean the Freedom Account is always better. Choosing the Freedom Account means paying more tax in the year of the contribution, because a Freedom Account contribution doesn’t reduce your taxable income. If the tax difference ends up as a difference in the total amount you save, it’s possible for the traditional account to come out ahead.
Example: You’re prepared to contribute $4,000 to a traditional IRA, but if you switch to the Freedom Account, you’ll cut back to $3,000 because you’re losing the tax deduction.
In this situation we can’t be sure which account will end up providing more wealth in retirement. Your Freedom Account starts out 25% smaller than the traditional IRA, and that means the traditional IRA can end up being more valuable if your tax rate in retirement is below 25%. Yet the Freedom Account has other advantages that can make it come out ahead.
Here’s the bottom line. To come out ahead with a traditional IRA, you have to contribute more money than you would have contributed to a Freedom Account. Even then, there’s a good chance the Freedom Account will provide you with more wealth in the long run.
Interested in finding out what your own Freedom Account would look like for you and your family? Contact Chris at chris@enspheremg.com today.
Mike Giffin, Ensphere Marketing Group
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