One on the neatest things you can do for yourself financially is to give yourself a raise courtesy of the IRS. Contributing to a tax deferred retirement account is a special form of saving money where the contributions are deducted from your taxable income. Often times you also get a small employer match - which is like getting free money on top of the tax break.

According to Vanguard only 10% of Americans enjoy an average 30% reduction in taxes by maxing out their retirement contributions (see the How America Saves 2017 report, page 37). People who do this are so called “super savers” and are among the most financially savvy individuals in the world. With 90% of the population not doing this, that is a lot of money being left on the table. However not everyone is fortunate enough or disciplined enough to do. Here is how you can capitalize on it.

How the Tax Benefit on Retirement Contributions Works:

Let’s say my wife and I have an adjusted gross income of $120,000. For sake of argument let’s say our tax rate is 28% federal and state combined after deductions, credits, and all the crazy rules and loopholes that go into taxes. At a 28% tax rate that means we pay roughly $33,600 in taxes.

If we each contribute $18,000 / year (maxing out our 401(k)s at work), that takes our adjusted gross income down to $84,000. That also lowers our marginal tax rate to 25%. So when we defer that income, we pay just $21,000 in taxes.

We save $12,600 on taxes by contributing to our retirement accounts. That is like getting a 10.5% raise and a 37.5% reduction in taxes - just for shuffling some money around!

The 37.5% tax break may be lower or higher given your situation. Consult with your CPA on the matter to be sure.

The $12,6000 Savings Comes With Strings Attached:

We get to “keep” that $12,600, but there are some strings attached:

1. We have to be willing and able to contribute $36,000 to our 401(k)s.
   With housing, child care, college tuition, and medical insurance being what it is, having extra money to save isn’t a matter of snapping your fingers. We had to put ourselves in position for this and it wasn’t automatic. There was also the nice stuff we didn't buy, like a big vacation, a luxury car (well maybe a lease on one), a kitchen remodel, etc.
    
2. Under this deal that money is stuck in our retirement accounts until we are at least 59.5 years old.
   Since we can’t spend it anytime soon, we are forced to take the long view. It is our money and we can withdraw it early, but it would count as income in that year and there would be a penalty. Depending on the reason there may not be a penalty (such as a medical emergency) but the typical penalty is 10%.
    
3. Our investment options are limited.
   We have to be comfortable investing that money into paper assets like mutual funds, ETFs, stocks, bonds. In the case of a 401(k) the investment options are dictated by the retirement plan selected by our employers. So, we can’t do things like buy a vacation rental, invest in cryptocurrency, or buy individual stocks (there are exceptions but that would not be typical under most company retirement plans).
    
4. This stuff is complex…
   Understanding how all this works was a time investment on our part. There is the IRS / tax code side and there is the investment side. I run the finances in our family since I have the interest in it, schooling for it, and work related experience. That said I include my wife 100% in all decisions. For the sake of my marriage I make sure she has a say, knows where things are, and has the ability to take over should I get hit by a bus or go into a coma.
    

Who Has Access to the Retirement Contribution Tax Benefit:

The tax code benefits people who have a moderately high income, a frugal lifestyle, or a blend of both.

The IRS sets limits on who can contribute to a retirement plan. It depends on your income, your age (under 50, over 50) and your filing status (single, married, etc). For example in 2018 Traditional IRAs eligibility begins to phase out at incomes above $62k for single files and $99k for married filers. For Roth IRAs eligibility begins to phase out at $118k for single filers and $186k for married filers.

Note that in 2019 the contribution limit goes up to $19,000 / year thanks to inflation.

As an aside - Roth accounts are a different animal in they apply to after tax contributions (meaning you pay taxes on the money, then contribute). So with Roth accounts there isn’t an immediate tax benefit. However the money grows tax free which can add up significantly, especially if you believe in the power of compounding returns. Plus with a Roth account you can withdraw the initial contribution whenever you want which makes it flexible.

The $18,000 per year figure I was using above applies to 401(k) plans provided through an employer. If you don’t have a 401(k) you are left with a Traditional IRA. That is unless you are self employed... Self employed people have the most flexibility when it comes to saving for retirement, read more on Self Employed Retirement Plans here.
 

What Could Deferring Income Do For You?

You don’t have to max out the retirement saving tax break to benefit from it.

According to our income spending simulator, a household earning $55,000 / year that defers 15% of their income can become a multi-millionaire. It takes about 30 years to get the first $1M, and the second $1M comes in the last 10 (thanks to asset appreciation and the power of compound interest).

It’s Not Just Okay to Save When You Are Young, It Is OUTSTANDING:

Getting into the habit of deferring income when you are young gives you two big benefits:

1. Developing a young habit of saving makes it easier to stick with over your lifetime.
2. Saving early on and saving often makes a huge difference because time is your friend when it comes to compounding interest! As the income spending simulation shows, most of the gains kick in at the end due to compound interest. The sooner you start on this ramp the better.

The more money you can put to work for yourself when you are young the more options you will have later in life. More options leads to less stress over saving for retirement later in the game.

Is This Tax Benefit For Everybody?

Unfortunately, after thinking about how this tax benefit works, I’ve realized it is gamed against the vast majority of people.

I just talked about how important it is for young people to save. However, practically speaking it would make sense to have an emergency fund, a down payment for a house, and debt under control before plowing income into paper assets like mutual funds, stocks, bonds, etc. So you have to be in a certain place in your life to entertain maxing out the benefit. Meanwhile, very high earners who are above the phase out limits for IRAs / Roth IRAs don’t get to participate either (but they are not hurting for money).
 

So the retirement tax deferral benefit is really only for:

1. Upper middle class households.
2. Who are established financially (own a home if they want to, have an emergency fund, and have debt under control).
3. Who live below their means.

It is only the people who prioritize making their money “work for them” that get to enjoy the benefit. There is a kind of income based “barrier” to get past and once you do, you get a tailwind courtesy of the IRS. Perversely by taking advantage of these tax breaks, you get a lower effective tax rate than the struggling poor and middle class families who lack the means to access it.