Advantages of Tax Deferred Plans
For better or worse, retirement savings accounts and other investment options don't come in a "one-size-fits-all" package. That is why asset "location" is just as important of a consideration as asset allocation. When setting aside funds for long-term goals such as retirement, tax-deferred accounts are an incredibly valuable device for effective and tax-efficient retirement saving.
Here are some important things to understand about various tax-deferred saving and investment options.
An account is tax-deferred if there is no tax due on the contributions or income earned in the account. The ability to defer taxes on the returns of an investment benefits individuals in two different ways. The primary benefit comes in the form of tax-free growth. As an alternative to paying tax on the current returns of an investment, taxes are paid only at a future date, allowing the investment to grow without current tax implications. The secondary benefit of tax-deferred investments is that they often occur during working years when earnings and taxes are most often higher than earnings and taxes during retirement. The use of a tax-deferred investment account is most often a wise decision when you are in a higher tax bracket now compared to the income tax bracket you anticipate to be taxed at in the future when you will be taking withdrawals.
Examples of Tax-Deferred Accounts
An employer-sponsored retirement plan (such as a 401(k), 457 or 403(b) plan) is an example of a tax-deferred retirement savings vehicle that allows participating employees to contribute a percentage of their pre-tax salary and direct it to one or more investment accounts. A regular IRA (also known as traditional) IRA is also tax-deferred. An annuity and the cash surrender value of a whole life insurance policy also operate as tax-deferred accounts.
A Roth IRA is not just tax-deferred; it is a tax-free account. It differs from a traditional IRA in the fact that your contributions are made with after-tax dollars. However, earnings grow tax-free and there are no taxes on withdrawals. An additional benefit has to do with Required Minimum Distributions (RMDs). While you are required to begin taking distributions from a traditional IRA starting at age 72, there is no RMD requirement for a Roth IRA.
A Health Savings Account (HSA) is also a tax-favored savings account that provides tax-deferred growth of earnings. Contributions are also made on a pre-tax basis, as are withdrawals, provided they are used to pay for qualified medical expenses. In that regard, you may hear HSAs also referred to as "triple tax-free." There are special rules regarding establishing an HSA, and not everyone will qualify.
Tax-Deferred Account vs. Tax-Exempt Account
Individuals can't establish tax-exempt accounts. However, they may invest in bonds which pay tax-exempt interest. Typically such interest is exempt from federal tax. However, if the bond represents the debt of a state other than the individual's residence, that interest will be taxable on his state income tax return.
When an Account Is Not Tax-Deferred
All investments have the potential to pay income, increase in value, or both. Income comes from two primary sources: interest and dividends. If an investment is held in a taxable account, the income is added to the owner's taxable income for the year and results in a higher tax liability. Any sales of assets held in a taxable account which are sold for more than what was invested will also result in increased income and income tax. No tax would be due if the same investments were held in a tax-deferred account—a significant advantage to holding investments in such a tax-deferred account.
Until When Is Tax-Deferred?
One day, you will pay the tax. The tax liability is triggered not by the investment performance, however. Instead, you will owe tax based on the amount of money you distribute to yourself, typically to pay for things you may want or need. As such, in an ideal situation, the income is not taxed until retirement, when you may be in a lower tax bracket. Even if your tax bracket does not decline in retirement, you are still likely to benefit from a tax-deferred account since it is far better to pay taxes in the future than in every year between now and when you would otherwise pay them.
Be aware, though, generally if take a distribution from a traditional IRA prior to reaching the age of 59 1/2 you will owe the tax plus a 10% penalty. It's different for a Roth IRA, however. If you decide to take a distribution prior to reaching 59 1/2, you can always take your contributions tax- and penalty-free. However, if you withdraw earnings from the account you will owe tax and may be subject to a 10% penalty. There are certain exceptions to these rules, so be sure to consult a qualified tax professional before taking any distributions prior to 59 1/2.
Tax Deductions on Tax-Deferred Accounts
Note that some tax-deferred accounts, such as a 401(k) or deductible IRA, provide for a tax deduction in the year you make the contribution. Not all tax-deferred accounts create such a deduction, however. In either case, the tax-deferred account provides for the deferral of tax during each subsequent year.