Hi! I’m so glad you wrote…this is a good question. In simple terms, “tax-deferred” means that you get to pay taxes later (in another year) rather than right now. Who of us doesn’t like to put off unpleasant things?! If I can get another year out of the roof on the house or put off getting a crown on a tooth, I’m happy to do so. So if you can pay income taxes later, it can be a great break. In addition to wanting to delay paying out money in general, the main reason people may choose a tax-deferred investment or plan is because they feel as if they will be in a lower tax bracket in the future when the tax becomes due.
The two main types of tax-deferred benefits for American taxpayers are some annuities and some retirement accounts. An annuity is an investment vehicle that combines features of insurance and investment and can provide tax-deferred growth. The main tax-deferred retirement accounts are the 401 (k) and the Individual Retirement Account (IRA). A 401(k) is a retirement savings plan offered to you through your work and managed by your employer. An IRA, on the other hand, is a retirement savings plan that you set up and manage on your own.
There are two primary types of IRAs: Traditional and Roth. The main differences between them lie in whenyou pay tax and whatyou pay tax on. With a Traditional IRA, you get to defer your taxes in the year you make a contribution to your IRA or 401(k). Tax deferral means that you don’t owe taxes that year on the money you just contributed (so if you contribute in 2016 your 2016 tax bill is reduced), but you will owe taxes on money you take out of the account later on in retirement. The assumption is that you will be in a lower tax bracket when you withdraw the money in retirement, so you end up paying less in taxes later than if you had paid the tax upfront. With a Roth IRA, you do pay taxes on your contributions (so the money you contribute in a given year is not tax-deferred), but when you withdraw the money in retirement, you don’t have to pay tax again. The interesting thing about a Roth IRA that makes it a good deal as I write this in 2016 is that the money you earn over the years that you are holding the money in your Roth IRA is never taxed – not during the years of holding or when you withdraw it. For an example, say that you contribute $4,000 of after-tax money a year to a Roth IRA for 30 years, making a total contribution of $4,000 times 30 or $120,000. Say that your investments over the 30 years in that Roth IRA made you $10,000. When you take this $10,000 out, you don’t have to pay tax on that money. In the IRS tax world, very few tax-free good deals like this exist.
One thing to keep in mind about retirement plans is that you want to avoid taking a “distribution” from them when you want to change plans or want to change the company who is holding your plan; you want to take a “rollover” so that you don’t accidentally take away the “tax-deferred” nature of the account and end up having to pay the taxes due that year. For example, when you leave a company for a new job, you can take your 401(k) to your new job or leave it in your former employer’s plan. You can also do a “rollover” of that retirement money into your own personal IRA or a new company’s 401(k). The term “rollover” is an important one to be aware of. If you take a “distribution” of your IRA or 401(k) before age 59½, you would likely incur a penalty for withdrawing that money in addition to having to pay the income tax on that sum. If you initiate a “rollover” of your IRA or 401(k), you move the money into another similar qualified retirement plan so that it retains its character as a qualified retirement investment vehicle and no penalty is incurred and income taxes continue to be deferred.
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