What Are Tax-deferred Accounts — and Why Are They Beneficial?
Tax day may finally be in the rear-view mirror, but that doesn’t mean you should forget about tax planning. In fact, now is a great time to get a jump start on tax planning for the rest of this year so you’re better prepared during tax season next year.
Contributing to a tax-deferred retirement plan is one of the best ways to reduce the amount of money owed to Uncle Sam each year. But what exactly is a “tax-deferred” investment and how do these plans work?
Deferring Taxes Until Later
A tax-deferred account is a type of investment in which tax is not currently due on earnings. Instead, the payment of tax is “deferred” until withdrawals begin at a later date, which is usually sometime in retirement for savings plans like traditional IRAs and 401(k)s.
There are two main benefits of tax deferral for most investors. The first is the fact that earnings are able to grow tax-free over a potentially long period of time. For example, a retirement saver who starts contributing to an IRA in his or her 20s could enjoy 40 or more years of tax-deferred earnings growth. This could result in a much larger retirement nest egg when compared to a similar taxable account.
The second main benefit of tax deferral is that many people are in a lower tax bracket when they withdraw funds in retirement than they are during their working years when they are making contributions. This can lower the amount of tax that is eventually paid on earnings that accumulate in a tax-deferred account.
What Constitutes Investment Earnings?
There are two main types of investment earnings (or income) that may be taxable: dividends and interest. Dividends are payments made by publicly held companies in order to distribute revenue to shareholder investors. Companies aren’t required to pay dividends and not all companies make dividend payments.
Investment earnings are also generated when securities are sold at a profit — this is referred to as a capital gain. For example, if you bought 200 shares of XYZ Corporation for $20 per share and sold them later for $40 per share, you would realize a capital gain of $4,000. At a long-term capital gains tax rate of 15%, the tax on this gain would be $600 if the investment were held outside of a tax-deferred account.
In addition to traditional IRAs and 401(k)s, other types of tax-deferred accounts include Health Savings Accounts (HSAs), annuities and whole life insurance policies. In addition to saving money on a tax-deferred basis to help pay for healthcare expenses, HSA funds can also be used to meet long-term financial goals like saving for retirement.
Even Better Than Tax Deferral
While tax-deferred accounts can be beneficial for lowering taxes, there’s another tax-advantaged account that’s even better in some situations. With Roth accounts, including Roth IRAs and Roth 401(k)s, investment earnings are generally tax-free if funds are left in the account until after age 59½.
Tax-free is obviously better than tax-deferred, so why would anyone choose a traditional over a Roth IRA or 401(k)? The primary reason is because with traditional IRAs, you may be able to deduct contributions from your current income. This can reduce your current tax liability.
If neither you nor your spouse participates in a retirement plan at your place of work, your traditional IRA contributions are fully deductible. However, if one of you does participate in a retirement plan at work, how much (if any) of your traditional IRA contribution is deductible will depend on your modified adjusted gross income.
Contributions to traditional 401(k)s aren’t deductible; instead, they reduce taxable earnings and thus current taxes. However, contributions to Roth IRAs are made with after-tax dollars — since the money has already been taxed, you won’t have to pay taxes on it again when you make withdrawals in retirement.
Start Planning Now
Spend some time now thinking about how you could utilize tax-deferred and tax-free accounts to reduce taxes and meet long-term financial goals like saving for retirement. Feel free to contact us if you have more questions about which type of account is best for your situation.