Taxed deferred growth allows individuals to increase their return on investments by “deferring” tax payments to a later date.
Now, we all now taxes are something we have to live with and there is no avoiding them completely. However, there are ways to reduce the impact of taxes on your earnings with specialized tax deferred plans that postpone payments until a much later date.
We’re talking decades.
If you’re in a higher tax bracket, or just looking for ways to better capitalize on your investments, then tax deferred accounts are something you should be interested in learning more about.
Did you know that the estimated median retirement savings were $117,000 for fifty-somethings? Nowhere near the recommended amount you need to keep up with rising living costs after retirement. Yet with so many different options in the market, it can be difficult to know how to effectively increase your savings balance.
What Is Tax Deferred Growth
Certain types of accounts, vehicles, and products allow the investor to defer paying the accrued taxes until a later date. We call these tax-deferred accounts. Tax-deferred accounts let you earn money on your investment now and pay any taxes (usually income and capital gains) further down the line.
The Difference Between Tax Deferred and Tax Exempt
Just to be very clear, tax deferred is not the same as tax exempt. You still pay your taxes for tax deferred accounts, just at a later date.
You as an individual cannot open a tax exempt account but you can invest in bonds that pay tax exempt interest. This is another way to maximize the return on your investment.
So, what are the options when it comes to tax deferring wages?
Examples of Tax-Deferred Accounts
Employer-sponsored retirement plans are examples of tax deferred vehicles that allow employees to direct pre-tax salary to investment accounts. These include 401(k), 457 or 403(b) plans.
Regular IRAs are also tax deferred and you can contribute to multiple plans. The value of the annuity and cash surrender of whole life insurance policies are also tax-deferred.
There are also tax favored savings accounts that allow for tax deferred growth such as a Health Savings Account. It’s worth noting that if an HSA is used to pay for qualified medical expenses, they are also tax-free.
Employee stock ownership investments are often tax deferred and act as an incentive for longer employment.
So, as you can see there are multiple ways to benefit from tax deference schemes depending on your situation and preferences.
But why are they so effective and how will they benefit you as an investor?
Why It Matters
Tax deferred growth benefits investors in two ways.
First, it allows the investor to earn on the compounding investment instead of paying taxes as they go. Which means they earn higher returns than taxed accounts in the long run.
Second, the benefit of tax deferred accounts is that they are usually put in place while the investor is in their highest tax bracket. When it comes time to access the tax-deferred account and need to pay taxes on the deferral, they may be retired and in a lower tax bracket.
This is why the higher your income tax bracket, the more beneficial it can be to use tax deferred accounts for your retirement savings.
In short, it matters because it will accumulate assets at a more rapid pace and avoid your higher tax rate by postponing the tax payments until a time you may be in a lower tax bracket.
If you’re a business owner and you’re looking into options to reduce and defer your tax payouts? Read our guide on the 7 different ways for you to effectively reduce taxes.
How It Works
Let’s give an example using the traditional Individual Retirement Account (IRA). If you decided to invest $10,000 into an IRA in 2020 and the account earns $1000 in 2020, you do not owe taxes on that $1000 in 2021. Instead, you will pay the taxes when you withdraw the money from the IRA, which could be decades from now.
So, let’s think about what that means for your increased earnings. If you are in a 45% tax bracket, you would have had to pay $450 in income tax on the 2020 earnings of $1000. Leaving with a net gain of $550.
If you’re making a 10% annual return on your investment, those earnings would, in turn, would leave you with $550 in 2021. However, if you used an investment, product, or vehicle providing tax deferral you would earn an ROI on the full $1000 instead of the $550 you would have had after paying your taxes.
So, as you defer the taxes each year you can see that the advantage will compound giving your high returns.
The last thing you should know is that there can be penalties incurred for anyone who withdraws funds before a certain allotted time has passed. That means you only really want to be using tax-deferred growth vehicles for long-term investments.
Earn Money Now, Pay Taxes Later
Using permanent life insurance as a tax deferral vehicle provides a unique opportunity for policy owners. Whether it’s whole life insurance or universal life insurance, the cash value growth in the policy is tax deferred.
If the policy owner desires to take withdrawals from the policy during retirement they can do so on a tax-exempt basis. This done via a combination of principal withdrawals and policy loans. This is one of the reasons the Restricted Property Trust can be so beneficial for a high-income earning business owner.
As we mentioned earlier, you can invest in multiple tax deferred savings plans, so look into different options to find the best allocation for you.
Above all, don’t be tempted to withdraw anything early and hold out until you’re in a more favorable tax bracket to reap the highest advantage from these accounts.
We hope our quick guide to tax deferred investments has given you the information you need to think about how you can improve your finances.
We also provide consultations and webinars to introduce you to the various tax reduction methods for your business or personal finances. Contact us here to find out more.