Don’t Make This Mistake When Contributing to Your 401(k) or SRS Account
It’s the year-end, and this means that many people start considering strategies to reduce their tax burden. After all, who likes to pay more taxes?
Well, that was a rhetorical question but maybe Starbucks likes paying more taxes, like they did this one time, but arguably that was for PR / marketing purposes too.
One strategy that many people around the world use is a tax-deductible investment account. Such an account allows you to defer taxes by claiming a tax deduction on the year you contribute, and only paying the taxes upon withdrawal (usually after a lengthy period of investing it).
They come in many forms. In the US, there are the 401(k)s and the Roth IRAs (one allows you to claim a tax deduction upfront, and one allows you to withdraw the money tax-free). In this case, I am referring to the 401(k) account, because it gives you the tax deduction upfront. The Roth IRA has its own benefits, but because you pay the tax upfront, you gain from the lack of taxes when you withdraw the money. But, because there are no capital gains taxes in Singapore anyway, the Roth IRA concept doesn’t apply to us.
Instead, for Singaporeans, the 401(k) equivalent is the Supplementary Retirement Scheme (SRS) account. This allows you to claim a tax deduction upfront, and only pay tax on 50% of the amount you withdraw later.
Now, the glaringly obvious point that other finance professionals talk about and harp on is the fact that you must invest the balances in your 401(k) and SRS accounts. Surprisingly, many people do not invest their balances, and that is the single biggest mistake that they make (because the money will just lose value due to inflation, AND you cannot use it as your emergency cash due to the penalties if you withdraw it before retirement).
Invest your 401(k) and SRS balances, people!
So, I’m going to stop here and just ask you to check your 401(k) or SRS account. If you still have any uninvested balances sitting there rotting away, stop reading and go and allocate it somewhere.
Now, I would take it that those who contribute to their 401(k) or SRS accounts are cognizant of the power of investing and compound returns, which is why you contributed to the account in the first place — to enjoy both the tax deduction and the investment gains. Many articles have been written advocating and optimising the use of the balances in those accounts, so I presume you are already doing that.
What I want to highlight is one mistake that many investment articles overlook — the actual tax savings that you get from the tax deduction.
It seems that this small (but substantial) tax saving is buried beneath the mountain of dealing with the actual balance in the 401(k) and SRS account, but over a long period of time (such as the life of the 401(k) or SRS account), these small savings add up. And adding up small savings is the whole point of compounding returns.
To illustrate the impact using the SRS, I am going to use the maximum allowable tax deduction for locals ($15,300) for each tax bracket, and compounding the return by 4% a year for 30 years (which is roughly the amount of time you will have before you need to withdraw the SRS account).
As you can see, the savings start to become significant when you have chargeable income above $40,000, since the marginal tax rate is then 7%.
This is the amount you can potentially earn by also investing the tax savings for one year. Imagine if you continued to invest the tax savings for the remaining 30 years as well!
I was going to say that I’ll leave the math to you… But hey, Excel to the rescue! This is of course, assuming you stay in the same tax bracket for all 30 years which is fairly unlikely:
Some Excel math for those who want to check the formula, I basically compounded each year’s tax savings with 1.04^(n-1) starting with n=31 since after 30 years, you only get to compound for 29 years in the following year, etc., and then summed the results once n-1 reached 0.
It does help that we have low tax rates (in general), so the amount of tax savings is smaller compared to a country with say, 30% to 40% marginal tax rates. But, if you overlook this small saving, you are potentially foregoing tens, if not a hundred, thousand dollars of potential returns that can complement your SRS account and personal portfolio.
“But wait!” you may say. “Which asset allows you to get risk-free returns of 4% p.a. for 30 years?”
Well, if you are unsure of that, you may want to check out this thing called the CPF Special Account… But that is a debate for another day.
So, while contributing to your 401(k) and SRS accounts is a good thing, don’t forget to make the actual tax savings work for you!
