No matter what age you are, it’s never too early (or too late) to think about retirement planning. One of the primary decisions you’ll make is to choose between a tax-deferred plan and a tax-exempt plan. This guide will help you understand more about tax deferral and how it can help you in your financial planning process.
What is tax deferral?
Tax deferral means that you will not immediately pay taxes on the contributions or earnings in your investment account. This investment strategy provides tax-free growth on the interest that your account accumulates.
Remember that you’ll have to pay taxes on these funds eventually: When you withdraw money in the future, it will be taxed at your ordinary income tax rate.
Benefits of tax deferral
Tax-deferred investments are designed for those who play the “long game,” financially speaking, which is why these types of accounts are ideal for retirement planning. There are two key advantages of tax-deferred accounts, including:
The primary benefit of tax deferral is that your earnings grow tax-free until the day you make your first withdrawal. Ordinarily, all contributions, dividends, and gains generated by an investment account are subject to tax. These costs can take a serious bite out of your long-term savings, especially in a high tax bracket.
For example, imagine that you open two different investment accounts. Each account holds $100,000, and both earn an interest rate of 8%. In other words, everything about these accounts is the same, except Account A is a taxable account and Account B is a tax-deferred account.
The gains from Account A will therefore be classified as taxable income and will be subject to a tax rate of 28%. The gains from Account B, on the other hand, can grow tax-deferred. After 20 years, Account A (the taxable account) will be worth $306,499. But Account B will be worth $466,096, a difference of nearly $160,000.
This demonstrates that tax-deferred growth allows investors to achieve significant gains over the long haul, which makes it an excellent choice for a retirement savings plan.
Takes advantage of lower tax bracket
Tax-deferred accounts also help investors take advantage of their changing tax liability. If you’re currently receiving income from a regular job, you’ll be in a higher tax bracket than when you retire. When paying taxes on withdrawals from the account, you’ll be in a low tax bracket, which means you’ll pay fewer taxes overall.
This tax strategy only works when you earn less taxable income, making it a valuable system for planning your retirement.
Tax deferral vs. tax-exempt accounts
Again, tax deferral doesn’t absolve you from having to pay taxes on these accounts. These accounts simply allow you to defer taxes until you withdraw funds or begin receiving distribution payments.
Tax-exempt accounts, on the other hand, are not taxed at withdrawal. Examples of tax-exempt accounts include:
- Roth IRAs
- 403(b) plans
- 529 education funds
- Health Savings Accounts (HSAs)
- Indexed universal life insurance policies
- Municipal bonds
- U.S. Series I and Series EE savings bonds (when used for certain educational expenses)
- Tax-free exchange-traded funds (ETFs)
Keep in mind that the benefits of tax exemption vary by account type. An HSA, for example, is completely tax-free as long as it is used for health and medical expenses.
Types of tax-deferred accounts
So far, it’s clear that tax deferral allows you to accumulate more money and only pay tax when you’re in a lower tax bracket. But the exact type of retirement savings accounts you should have depends on your employment status, financial goals, and comfort level with different investment vehicles.
There are five basic types of tax-deferred accounts that you can use for long-term financial planning.
Employer-Sponsored Retirement Plans
If you work for a large organization, you’re likely eligible for an employer-sponsored retirement plan, such as a 401(k). Common types of employer-sponsored programs include:
- 457 plan
In each case, the plan is funded by pre-tax payroll deductions and may also include matching contributions from your employer. The fundamental difference between each retirement plan is the type of employer.
A 401(k) is the most common and will be offered by a for-profit business. A nonprofit typically provides a 403(b), while some state and local governments offer a 457 plan to their employees.
Small business retirement planning
What if you’re self-employed? Solo entrepreneurs are not eligible for traditional retirement plans such as a 401(k), but they may still take advantage of tax-advantaged accounts.
For example, solo business operators can open a SEP-IRA plan, which stands for “Simplified Employee Pension.” This account allows you to provide retirement benefits to yourself on a pre-tax basis. Small business owners may also set up a SIMPLE IRA if they have fewer than 100 employees.
Some employers offer their employees a pension. The exact nature and amount of these pensions are as varied as the companies that provide them, but employers generally fund these pensions on behalf of their employees. The recipient will pay income tax once they begin to receive distributions from their pension.
Individual retirement accounts
If you don’t receive retirement benefits through your employer, you might consider setting up an Individual Retirement Account or IRA. IRAs are often tax-deferred, though some may be tax-exempt.
In a traditional IRA, you’ll contribute pre-tax dollars to avoid having to pay tax on your IRA contributions. Then, like any tax-deferred account, you’ll pay income tax in the tax year that you access these funds. Once this happens, these funds will be taxed as ordinary income.
Roth IRAs work differently – “Roth” accounts are always tax-exempt. After you retire, you can withdraw funds from your Roth IRA without paying any tax. However, you’ll have to fund your Roth IRA with after-tax dollars, which means you’ll pay tax on your income before adding it to your Roth IRA.
Remember: Roth IRAs and traditional IRAs are pretty different. Only a traditional IRA is tax-deferred.
Additionally, the IRS limits the amount you can contribute to either a Roth IRA or a traditional IRA. There is also a 10% penalty if you make any withdrawals before you turn 59.5 years old.
Other qualified annuities
An annuity is a financial vehicle designed to provide a series of payments to the recipient, giving you a guaranteed income stream once you retire.
A qualified annuity refers to an annuity purchased with pre-tax dollars and is often called a “tax-deferred annuity.” A traditional IRA and a 401(k) are both qualified annuities. The total amount of each distribution will be taxed as regular income.
However, some less common qualified annuities may allow you to make larger contributions, making this vehicle far more flexible than some of the other options listed above.
Advantages of taxable accounts
Some investment vehicles are not eligible for tax deferral. For example, suppose you’ve invested in certain types of brokerage accounts or money market mutual funds. In that case, you must report your contributions and earnings to the Internal Revenue Service (IRS), and you may have to pay capital gains tax for these earnings.
With so many advantages of tax-deferred retirement accounts, why might you consider investing in any form of taxable account? Reasons vary, but these other accounts may offer a greater financial benefit that makes the tax rates worth it.
You are limited in the amount you can contribute yearly to most tax-deferred retirement accounts. In addition, certain types of investment accounts may offer a greater chance of return than the tax-deferred examples listed above, though they may require additional tax planning.
Tips for retirement and tax planning
Understandably, this is a lot to think about. Which retirement account is right for you? That question can be difficult. Consult a tax advisor or other financial professional if you’re having doubts. Here is some general guidance.
Choose the plan that matches your income
Low-income earners won’t see much benefit from a tax-deferred account. These individuals already occupy a relatively low tax bracket, so it doesn’t matter how long they defer taxes. You will likely benefit from a tax-exempt plan if you’re in a low tax bracket.
On the other hand, a tax-deferred retirement plan makes sense if you’re in a high tax bracket. You’ll still have to satisfy your tax obligations, but after you retire, your income will be low enough that your tax obligation should be much lower.
Check with your employer
If your employer offers a qualified retirement plan, it may be to your benefit to augment what’s already in place. For example, if your company matches your retirement contributions, you should take advantage of this perk and grow your retirement savings with the help of your place of business.
What’s your risk tolerance?
There are many ways to invest. Often a tax-deferred plan such as an IRA or 401(k) can be invested in a mutual fund. But individual investors can also take advantage of index funds or other investments to provide future periods of income.
These other investment strategies don’t offer the same tax benefits as other retirement plans, but they may offer a more significant promise of future rewards. The flip side is that these investments pose a greater risk than the tax-deferred strategies listed above.
Don’t neglect your HSA
As you get older, your health will become a greater priority. According to a 2021 study, 20% of older Americans spent more than $2,000 on out-of-pocket health expenses during the year. A Health Savings Account is a tax-free account, and though its purposes are narrow, it provides a valuable safety net as you enter your golden years.
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Frequently asked questions
You’ll want to consult a certified public accountant or another financial professional for specific retirement and tax advice. However, the following are the most commonly asked questions about retirement accounts:
Each time you receive a distribution from your tax-deferred account, the IRS classifies this as income. In other words, your tax-deferred account becomes your source of income. Each time you make a withdrawal or receive a distribution, you’ll be subject to your ordinary income tax rate.
When you make contributions to your tax-deferred account, you won’t have to pay tax on that money. Depending on your retirement plan, you may be able to deduct these contributions from your income tax return, though you should always check with a tax professional before doing so.
Once you receive money from your tax-deferred account, it will be taxed as ordinary income. You’ll have to pay tax on this money the same way you would if you were receiving a paycheck from an employer.
This depends on your investment vehicle. For example, the IRS specifies that if you have a traditional IRA, required minimum distributions (RMDs) kick in at age 72. This doesn’t apply to a Roth IRA, but every investment vehicle may have its own requirements regarding when you have to begin receiving reimbursements.