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Retirement Accounts: Should You Fear the Eventual Tax Bill?

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For Women & Co. by Jonathan Clements, Director of Financial Education, Citi Personal Wealth Management

Some people are reluctant to fund Individual Retirement Accounts and 401(k) plans, fearing they are setting themselves up for big tax bills in retirement. After all, retirement-account withdrawals are typically taxed as ordinary income, which can mean paying a federal rate as high as 39.6 percent in 2013. By contrast, in a taxable account, any qualifying dividends and long-term capital gains are taxed at a maximum federal rate of 20 percent.

What to do? If you're eligible, you can always fund a Roth IRA or Roth 401(k) instead. Roth accounts don't offer an initial tax deduction, but withdrawals can be federal and state tax-free if you follow the rules. But even if the Roth isn't an option, a tax-deductible IRA or 401(k) remains a fine choice. That's because the initial tax deduction often pays for the eventual tax bill.

To understand why, consider a simple example. Suppose you are in the 25 percent federal income-tax bracket today -- and you're still in the 25 percent bracket once you retire. If you put $1,000 in a tax-deductible IRA, your out-of-pocket cost would be $750, thanks to the $250 tax savings.

By the time you retire, let's assume your IRA has grown a hypothetical 100 percent to $2,000 (though there are, of course, no guarantees). At that juncture, you cash out the account, paying 25 percent to the government. That leaves you with $1,500, or 100 percent more than your $750 investment. In effect, the IRA gave you tax-free growth on your initial $750 out-of-pocket cost.

To be sure, if you are in a higher tax bracket in retirement, you won't enjoy totally tax-free growth. On the other hand, if your tax bracket falls in retirement -- which often happens -- you will benefit at Uncle Sam's expense.

Women & Co., a service of Citi, is the go-to personal finance source for women. By providing financial content, commentary and community, Women & Co.'s mission is to get women thinking and talking about personal finance. Founded in 2000, Women & Co. is one of the longest running personal finance websites dedicated to helping women strengthen their financial futures.