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Tax-deferred means delaying tax payments on investment earnings until you withdraw or otherwise receive them. IRAs are a common tax-deferred investment example.
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In the lead-up to early retirement, you need to be making the right choices with your investments to achieve financial freedom. One of the best ways to do that is avoiding taxes whenever legally possible. But you can’t always do that, so what’s your next-best option?
You can elect to have some income taxes deferred, meaning delaying tax payments on certain types of income and investments until later. This can save you big money on taxes in retirement, especially if you end up in a higher tax bracket when the time comes. Even if you are in a comparable, or lower, income tax bracket in retirement, reducing tax drag may still create more long-term value.
In this guide, we’ll dig into the meaning of tax-deferred income, name the top benefits of deferring taxes, and give examples of how to defer taxes with certain accounts.
Tax deferral is postponing tax payments until you collect the investments or payouts from a tax-deferred account at a later date. It’s like doing a financial tango with the IRS that promises to last a certain amount of time while you kick the tax can further down the road.
If you’re stashing money into a tax-deferred account, like a traditional IRA or a 401(k), the IRS essentially grants you a temporary tax shelter. The money you contribute to these accounts doesn’t immediately count as taxable income.
Income tax deferral can help your investments compound over time without tax liabilities slowing your gains. However, in most cases, you can’t touch your investments without incurring a penalty.
When you eventually withdraw the money from your tax-deferred accounts, Uncle Sam returns, hat in hand, expecting his cut. And if you’re in a higher tax bracket than when you initially contributed the money, you might be playing a losing game.
Tax deferral isn’t just fancy finance jargon – it’s a potent strategy that can boost your wealth over the long haul. Now, let’s dive into the top benefits that tax-deferred growth offers.
When growing your wealth, little beats the power of compounding. Tax-deferred accounts are one way to take advantage of this phenomenon because your pre-tax investments can grow without taxes constantly nipping at their heels.
So, your returns generate returns, and those returns generate more returns, creating a snowball effect of wealth accumulation. The longer you leave your money invested, the larger this snowball becomes and the faster it grows over time.
If you’re earning a comfortable income but would rather hold off on handing a chunk of it over to the IRS, tax-deferred accounts let you reduce your taxable income today. By contributing to these accounts, you’re telling the IRS: “Hold off on those taxes for now, I owe you.”
This lowers your current tax bill and frees up more money to invest.
As of 2023, you can also claim a deduction on contributions to an IRA if you don’t contribute to an employer-sponsored plan or if you do contribute to one but your modified adjusted gross income is less than $73,000.
Fast-forward to your retirement years. Chances are, your income looks quite different. Tax-deferred accounts allow you to postpone taxes, so you can strategically withdraw money when your tax rate is lower.
However, you might have a higher income during retirement and fall into a higher tax bracket. In that case, a backdoor Roth IRA could be a better option today than a tax-deferred account since your returns and withdrawals in retirement will all be tax-free. A backdoor Roth IRA is when you take after-tax funds in a traditional IRA and move them to an after-tax Roth IRA – that is if you make too much money to contribute directly to a Roth IRA.
Your financial legacy matters and tax-deferred accounts can be pivotal in estate planning. When you pass away, these accounts can be left to your heirs with potential tax advantages.
This means you can pass on your hard-earned wealth more efficiently, helping your loved ones navigate their financial journeys with fewer tax burdens. That way, you’re passing on wealth and the knowledge that tax minimization helps build bigger piggy banks over time.
Tax-deferred accounts complement a well-rounded investment portfolio. Asset location helps you manage and possibly reduce your tax liability over time: your least-tax-efficient assets go into a tax-deferred IRA and that reduces tax drag.
By diversifying your assets, you have a mix of tax-deferred, tax-free, and taxable assets in retirement so that no matter what happens to the tax code you have options.
Finally, and most importantly, tax deferral helps you prepare for retirement. It ensures you have a financial cushion to support your lifestyle when you leave the workforce.
By reducing your tax liabilities in retirement, you can enjoy your golden years with greater financial security.
To take advantage of tax deferral, you should know the common types of accounts that fit this strategy, as well as other tax-minimization strategies that complement tax deferral.
There are four main types of deferral investments:
There are also SEP and SIMPLE IRAs. A SEP-IRA is only for employers to contribute to their and their employees’ accounts, while a SIMPLE account is for businesses with less than 100 workers and takes contributions from both employers and employees for employee accounts.
Pension plans are also a tax deferral strategy if one is available to you. However, only certain employers in select sectors offer them. If you have a pension plan, your contributions aren’t taxed until you withdraw from the fund.
There are a lot of factors that go into finding the right mix of accounts. Playbook builds the plan to help you know you're doing the right thing with your money.
The main difference between tax-deferred vs. tax-free is that you contribute pre-tax income to tax-deferred accounts and pay taxes later on your withdrawals, while you contribute post-tax income to tax-free accounts and pay no taxes on what you pull out later.
Common tax-advantaged accounts are Roth IRAs and health savings accounts (HSAs).
If you follow the rules with a tax-advantaged account, you’ll even be able to enjoy your spoils tax-free. That is, the gains your tax-advantaged account earns before you withdraw it out won’t incur any tax penalties. This makes tax-advantaged accounts a huge bounty for early retirement wannabes.
Here are some other key differences between tax-deferred and tax-advantaged accounts:
Generally, for those who foresee their tax bracket decreasing in retirement, tax-free investments will provide a superior wealth-building option. With no tax drag and a flexible withdrawal strategy, tax-advantaged accounts make retirement planning simpler.
Tax deferral isn’t the only way to grow your wealth until it’s long in the tooth. Try these complementary strategies:
Tax deferral isn’t just about avoiding taxes today; it’s about harnessing the power of time and smart financial planning to build lasting wealth. It’s a secret weapon on the journey to financial freedom, allowing you to keep more money, protect your assets, and pave the way for a brighter financial future.
Your other secret weapon is Playbook. We help you take control of your financial goals and build wealth over time so you can retire earlier – all the while, you get to take your mind off your money and let it grow in peace.