IRA, short for Individual Retirement Account, along with 401(k) retirement accounts, constitutes a significant portion of the funds that Americans save for their retirement years.
During our working lives, we earn employment income, which we allocate for daily expenses and set aside for future needs, including retirement. Retirement is defined as the phase where one stops full-time employment.
Upon retirement, we lose the steady wages from full-time work, and although some may receive pension income or work part-time, the overall expectation is a decrease in income. To offset this shortfall, we may rely on income from investments or draw from the accumulated wealth.
Consequently, setting aside money for retirement is essential for most individuals, as few have pre-existing funds from inheritance or family gifts to rely on. Saving for retirement becomes crucial to avoid living on a significantly reduced income during retirement.
Even if someone has no need or desire to save for retirement, retirement accounts can still serve a purpose for tax benefits. For instance, a Roth IRA enables individuals to earn investment income without facing tax consequences, making it beneficial for anyone, regardless of their wealth, to take advantage of such tax-saving opportunities.
Paying less tax is preferable for everyone, including the wealthy, and IRAs can help in this regard. Despite certain income limits on IRAs, the government encourages tax-saving strategies, making it sensible to utilize these opportunities to our advantage.
Governments Seek to Make Taxation Fairer Through IRAs
The rationale behind tax breaks on retirement savings is not always explicitly discussed, but governments generally implement them for specific purposes they consider important. One such purpose could be promoting fairness, benefiting both individuals covered by the tax breaks and the overall country.
Progressive income tax systems mean higher-income earners pay a higher percentage of their income in taxes. Whether this is fair or not is a subject of debate, but regardless, there is an opportunity to make the system fairer by considering longer periods, even spanning one’s lifetime, rather than just yearly income.
For example, instead of solely assessing annual income, we could look at someone’s lifetime earnings and determine a tax rate based on that cumulative amount. This approach resembles how we handle capital gains and losses, allowing us to smooth out tax calculations and make them more comprehensive.
Currently, annual tax calculations may lead to individuals with fluctuating incomes paying more taxes than if their earnings were averaged out. Retirement accounts like IRAs aim to address this by deferring taxation on certain income until the future, where the tax rate might be lower. This perspective considers cumulative contributions over time and reduces the impact of progressive taxation, ensuring a fairer outcome when someone’s income significantly decreases in retirement.
While smoothing techniques can be beneficial, they don’t apply to cases where income remains consistent in retirement. The uncertainty surrounding retirement income, which is influenced by various factors, such as investment performance, makes it challenging to predict one’s financial situation accurately.
To achieve greater fairness, the tax savings provided by traditional retirement accounts could be contingent on a lowered tax bracket in retirement. This ensures that those who genuinely need the savings due to reduced income in retirement receive the benefit, preventing undeserving individuals from exploiting the system.
The Government Also Wants People to Save for Retirement
During our working years, we are considered net contributors to government funds through our taxes. However, upon retirement, as we stop working and start receiving social security payments and healthcare subsidies, we become beneficiaries of social programs, taking more from the system than we contribute. This shift from taxpayers to recipients raises concerns about the sustainability of these programs in the future.
There is a genuine worry that social security payments and Medicare may face significant cuts, leaving people more reliant on their own resources. Many individuals already struggle financially due to insufficient retirement savings, and this situation could worsen in the future.
To address this issue, it is crucial to encourage people to save more for retirement. Despite some people managing their retirement savings reasonably well, the majority should be doing more. The government plays a role in this by offering tax incentives to promote retirement savings and implementing rules that discourage early withdrawals, encouraging individuals to save for their retirement years.
Both individuals and the country benefit from having financially secure retirees. While they may not enjoy the same level of prosperity as during their working years, it is essential to ensure they are reasonably well off. This preparation is vital, particularly in the face of potential shortcomings in social safety nets. By incentivizing retirement savings through vehicles like IRA accounts, the government helps individuals become better prepared for financial challenges in retirement, especially if they must rely more on their personal resources.
This Makes a Lot of Sense for Individuals as Well
The human tendency to prefer the present over the future is natural and understandable. It is reasonable to discount the future to some extent, but we must avoid completely disregarding it. Saving money can be challenging for many individuals, as the allure of immediate spending often outweighs the potential benefits of saving for the future.
In our decision-making, we often give insufficient weight to the future, leading to excessive discounting. While some level of discounting may make sense, it should not lead to outright neglect of our future needs. We tend to focus on the present and the near future, often overlooking events or needs that may arise decades later due to their intangibility.
While some people plan their finances for the future effectively, many others do not, irrespective of the tax advantages offered by retirement accounts. Surprisingly, a large percentage of Americans do not have an IRA or Roth IRA, even though these accounts often make financial sense.
The ideal approach is to view our finances holistically, recognizing that our present spending affects what we will have available in the future. Striking the right balance between the present and the future is essential. Though there is a chance that some of us may not live long enough to see the future, it is crucial to prepare for the possibility and ensure financial security for our later years.
Saving enough for retirement can be challenging, particularly when most income is allocated to basic necessities, leaving little room for savings. However, even in such circumstances, it is crucial to make an effort to save and do our best to secure our financial future.
IRAs play a significant role in helping us achieve our retirement goals by setting us on the right path and providing rules that encourage continued saving. The tax advantages associated with IRAs, whether through deferred taxes and compound gains with traditional IRAs or tax-free compounding with Roth IRAs, further motivate us to save for retirement.
While IRAs are valuable tools, they require a strong commitment to the savings process. Ultimately, through careful planning and disciplined saving, we can work towards a financially secure retirement and strike a balance between our current and future financial needs.
