Tax-Deferred Investing


The great appeal of tax-deferred investing is that it lower your tax bill now.

When you invest through a tax-deferred account, you postpone income tax on earnings your investments may provide until you withdraw money from your account.

What’s more, you owe no current income tax on capital gains you might realize from selling investments in the tax-deferred account. That means you can reinvest the entire amount of any realized gain, and you don’t have to share any of your profit with the IRS until you withdraw.

For example, if you bought 200 shares of stock in your tax-deferred account for $20 a share and the price increased to $100 a share, you could sell and reinvest the entire $20,000 sale price. (Transaction expenses would be subtracted on the sale and on the reinvestment.)

In contrast, in a taxable account, you’d owe $2,400 in capital gains tax (assuming you’d held the stock for more than a year and you pay capital gains tax at the 15% rate) and would have only $17,600 left to reinvest. You can continue to sell and reinvest in your tax-deferred account for as long as the account is open, taking advantage of increases in investment value and opportunities for new investment.

Over the long term, postponing tax on earnings and capital gains, even when they’re calculated at the low long-term rate, creates the potential for significant growth in your tax-deferred account.


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TYPES OF PLANS

There are various types of tax-deferred plans, including:

All of these plans are similar in the sense that investments you make with money you put into the plans can accumulate tax-deferred earnings. And, with each type of plan, you may owe a federal tax penalty plus the income tax that’s due for taking money out of the account before you turn 59½ — though there are some situations when the penalty may not apply.

But there are some important differences among these tax-deferred plans as well, resulting from the federal laws that govern their operation. Those differences include the source of the money you contribute, whether or not you’re required to begin taking money out of your account when you reach a certain age, and whether those withdrawals are taxed.


PLAYING THE TAX GAME

You pay income tax on money you withdraw from your tax-deferred accounts at whatever your tax rate is for the year you withdraw. For example, if your adjusted gross income, including the amount you’ve withdrawn, puts you in the 25% federal bracket, that’s the top rate at which you pay tax, and the one that will apply to your withdrawal amount.

You may wonder if you’ll end up owing more tax on the money you eventually take out of your tax-deferred account than you would have paid in tax at the time you earned the money. Realistically, there’s no way to tell. Tax rates change over time, depending on a number of factors. What you earn changes as well. That means you might have more income after you retire than in many of the years you contributed to a tax-deferred plan. Or all levels of income may be taxed at a higher — or lower — rate. But, despite the uncertainty, most experts agree that the potential benefits of tax-deferral are worth the risk.

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SPLITTING HAIRS

While you’ll hear lots of talk about tax-deferred investments, it’s actually the account or, in the case of a retirement savings plan, the plan that’s tax deferred. Any earnings on money you’ve contributed are tax deferred because the investments are held in the account or plan.

That’s why an investment might be tax deferred if purchased with money you’ve put into a 401(k) plan, but not tax deferred if you bought that same investment for your taxable investment portfolio.


SETTING THE RECORD STRAIGHT

Did you ever wonder why a tax-deferred investment earns more than the same investment in a taxable account? Actually, it doesn’t. But the earnings aren’t the issue. Your bottom line is.

For example, suppose that, on the same day, you bought $3,000 worth of mutual fund shares for your tax-deferred IRA and $3,000 worth of shares in the same mutual fund as a regular, taxable investment. Suppose, too, that you had the earnings reinvested, and you left both investments alone for ten years. What you’d discover is that both accounts would have exactly the same value. So, you might ask, what is all the fuss about?

It’s taxes. Each year during the ten-year period, you would have owed tax on all the earnings that were reinvested in the taxable account. As long as you had enough on hand to pay your bill, or you could offset any capital gains with investment losses, you could let your investment compound. But whatever you paid in taxes would reduce the amount you had available to spend or invest elsewhere.

In contrast, you’d owe no tax on the tax-deferred account during the ten years. In fact, if you didn’t withdraw for 30 years, you’d owe no tax during that period either. That means as any earnings compound, they form a larger base on which additional earnings may accumulate.

And because there are potential penalties for early withdrawals, you may be more inclined to leave your retirement savings alone until you actually retire.