The answer is simple – maximize contributions to your retirement accounts.
A key to building wealth is “Don’t turn down free money.” When you maximize contributions to your employer retirement plans and Individual Retirement Accounts (IRA) you keep three types of free money:
- Taxes you normally owe the government
- Interest earned on the government’s tax dollars
- Interest earned on the interest (compound interest)
By maximizing your pre-tax contributions you accept the government’s “free” money, build wealth faster and are able to retire sooner.
The amount of free money varies with your marginal tax rate. In the USA we have a progressive income tax code. The more you earn, the higher your tax rate. Your marginal tax rate is the amount of taxes you paid on the last dollar (“at the margin”) you earned.
If your marginal tax rate (federal and state) is 30%, then for the last dollar you earned you paid 30 cents in taxes. In essence you get to keep only 70 cents of the dollar you earned. At the margin the government is now keeping almost 1/3 of your income.
Think of tax deferral as an instant and certain return on your $1 investment. Most people are very happy if they get a 10% return on their investment over one year. When you put money into your QRP or deductible IRA you receive an instant and certain return of 15-50% (depending on your tax rate) on your investment. Which would you rather have, a possible 10% return on your investment or a 15-50% instant and certain return?