The world of taxes can be complicated. There are a ton of words and acronyms which can be confusing to understand if you don’t have a finance or accounting background. Tax-deferred is one of those tax terms that is often misunderstood. If you’ve never heard of tax-deferred before, or if you want to better understand it, read on!
How Does a Tax Deferral Work?
What exactly is a tax deferral? Simply put, a tax-deferral is when an individual or a company postpones paying their tax liability until a later date in the future. Tax-deferrals can have numerous benefits, and can be used in a variety of ways/circumstances.
What Are Tax Deferrals Used for?
Tax-deferrals, in the personal finance world, allow an investor to postpone paying taxes on capital gains until a later date. Most commonly, tax deferrals are used in investment accounts. By keeping 100% of the profit in the account, and growing the account size, an investor has the ability to earn more profit in subsequent years.
What Are the Benefits of Tax Deferrals?
There are numerous benefits and reasons why someone would want to defer their taxes on various investments.
First and foremost, deferring taxes until a later period allows your money to compound at a faster rate. Imagine if you were investing $100,000 and earned a 10% rate of return for year one, or $10,000. Instead of paying capital gains tax on that $10,000, you can roll 100% of the profit into the principal balance. In year two, you have the ability to generate a rate of return on $110,000.
Secondly, deferring taxes until a later point of time, ideally retirement, allows you to reduce your tax liability. Considering one’s income typically declines in their retirement years, their tax liability, or tax bracket, will likely also decline. For example, instead of paying a 25% tax rate, you may pay a 15% tax rate in retirement.
What Is an Example of Tax Deferrals?
There are numerous examples of tax deferrals you may be familiar with. These include, 401(k) plans, 403(b) plans, and various IRA accounts.
Types of Tax-Deferred Investment Accounts
There are several tax deferred types of accounts. Let’s unpack these tax deferred accounts in greater detail.
A traditional IRA, or individual retirement account, is an account that allows one to save money for their retirement in a tax deferred fashion. The profit or return one receives each year will be rolled into the principal balance, allowing for the account value to grow at a faster rate.
In retirement, you can begin to withdraw money from this account as a secondary source of income, and chances are your tax bracket will be lower than what it was when you were working.
401(k) and 403(b) Retirement Plans
A 401(k) is an employer-sponsored retirement plan. These retirement plans allow the employee to contribute a portion of their salary to this investment vehicle. Earnings/profit in a 401(k) plan grow on a tax-deferred basis. Another additional benefit is the fact that many employers will also contribute to the employees 401(k) via a match. For example, if the company matches 4% of the employees salary into the plan, the employee is essentially getting ‘free’ money if they contribute to their own 401(k).
A 403(b) is very similar to a 401(k), but it is designed for employees of public schools, or various tax exempt organizations. There are some legal differences between both a 401(k) and 403(b). Like a 401(k), a 403(b) allows the employee to allocate a specific portion of their salary in this tax deferred or tax sheltered account.
A variable annuity is an annuity with a variable rate of return. The return can increase or decrease depending on the underlying performance of the portfolio. These annuities typically come with higher fees and a greater risk profile, but the advantages are attractive.
First and foremost, variable annuities are a great tax-deferred investment vehicle. Secondly, there is a guaranteed death benefit. Lastly, when the underlying portfolio performs well, the return one receives will be attractive.
Fixed Deferred Annuities
A fixed deferred annuity is an annuity product issued by an insurance agency or investment firm. Unlike a variable rate annuity, a fixed annuity will provide a fixed rate of return for a given period of time, which is arguably both the greatest advantage and disadvantage of this investment vehicle.
No matter the market condition, a fixed annuity will provide the same rate of return. This is great when the market is not performing well, but when the market performs well and earns a greater rate of return, you may be disappointed.
These annuities also allow your money, and interest, to grow tax deferred until withdrawing it at 59 ½. If withdrawn earlier, you’ll need to pay full tax on your profit.
An I bond is an interest-bearing savings bond issued by the United States government. These bonds give the investor a return, although the rate of return is not exactly high or lucrative. The fixed interest rate will adjust twice a year based on inflation. The biggest advantage of I Bonds is the fact that these are considered a very low risk investment option, and also presents tax deferred benefits.
What Is Deferred Income Tax?
Deferred income tax is when a company defers paying tax on income for a period of time. There are numerous reasons why this may occur. For example, a company may recognize revenue at a time where tax laws were changing, and needed to defer this liability as they were unprepared for this change. The way a company depreciates assets may also be a culprit.
What Is Tax Deferred Growth?
Tax deferred growth is simply when a company or individual earns money now, but pays taxes on that money later. This is most common in the world of investing, and various investment vehicles provide tax deferred benefits.
What Is a Tax Deferred Exchange?
A form 1031 tax deferred exchange allows someone to sell an appreciated asset(s), which is typically real estate, and defer paying taxes on the capital gain. Instead of paying taxes on the capital gain, the individual must use that profit to purchase another property.
Why Are Tax Deferrals Important?
Tax deferrals are important because it allows an individual or company to increase their purchasing power at a faster rate. Following the example we went over above, where the individual invested $100,000 and earned a 10% return in year one, imagine if the individual had to pay a 25% tax on that $10,000 profit. Instead of being able to invest $110,000 in year 2, they would only be able to invest $107,500. That would reduce how much profit one could potentially earn in year two.
A company also benefits from tax deferrals as it gives more liquidity to the company in the present day. The company can use that liquidity, or cash, to generate a greater return, or make larger investments.
What Is the Difference Between Tax Free and Tax Deferral?
A tax free account is an account where the account owner pays no taxes when they withdraw the money in their retirement. No tax is paid at retirement, because the tax is paid upfront when deposited. A tax deferral is when the tax liability is postponed to a later date.
One may choose to invest in a tax free retirement account if they believe taxes are going to go up by the time they retire. One may choose to do a tax deferral if they believe their tax bracket in retirement will be less than what their existing tax bracket is.
Taxes Are Complicated, Advice Helps!
Taxes can be complicated! A small mistake, or not knowing the various tax laws, nuances, and practices, can cost you a lot of money. Understanding how to reduce your tax liability and maximize your return is not easy, but it is certainly worth it.
Working with a professional financial advisor can help make sense of the tax world, and the various investment vehicles that will serve you well. Financial advisors will help you manage your money, and will help you achieve your financial goals. They’ll present you with various tax free and tax deferral options, and will help you make the right decision.