People are always talking about how important it is to start saving early for retirement. But just how much difference can a few years make? A lot, actually. In this article, we'll explain the basics of tax-deferred investments and how they allow you to make sound decisions regarding your financial future. Prepare to be amazed at the power of tax-deferred growth!
Many financial planners advocate the benefits of having a diverse financial portfolio that includes a mix of tax deferred investments - and for good reason. Deferring taxes can be a highly effective tool when it comes to your financial investments. Today, there are several tax-deferred investments that can provide a sound long-term strategy for setting aside money in which to save for retirement.
What does tax-deferred mean?
Simply put, the term tax deferred means that you can postpone paying income taxes at a later date, typically in retirement when you begin to draw income. And, you'll only pay taxes on the amount that you withdraw from your tax-deferred accounts, while the rest of your money can continue to grow tax-deferred.
Waiting has its advantages
There are two basic benefits of a tax deferral on your investments. First is tax-free growth. That means that you won't be subject to paying income taxes on the returns earned on your retirement accounts today, but at a later date in the future. This allows you to put more of your money to work right away, as well as reducing your current taxable income.
The second benefit to tax deferred investments is that the contributions in your tax-deferred accounts are often made at a time when you're earning a higher income and are typically subject to a higher tax rate. So when it comes time to retire and begin withdrawing income (distributions) from your tax-deferred accounts, you may find yourself in a lower tax bracket and paying less income tax on your withdrawal than you would have when you originally invested your money.
What types of accounts offer tax-deferred growth?
Accounts that are considered tax-deferred typically include traditional IRAs, Roth IRAs, Keogh plans, and a variety of 401(k) plans - including those that cover self-employed persons. There are also many insurance-related vehicles, such as tax-deferred annuities and certain life insurance contracts that may also provide tax-deferred benefits.
Thanks to the magic of compounding, the contributions that you make in your tax deferred investment accounts allow you to grow both your principal and any additional earnings that you may have accumulated, tax-deferred. This means that your money grows at a faster rate, making a big difference in the growth of your nest egg.
Tax-deferred growth can be a great way to save and earn a return on your money. But remember, at some point you will be taxed on any profits that you make - no matter how you earned it. The question is at what rate you'll be taxed and when.
At Protective Life, we think that the more you know about your financial investments the better. If you want to learn more about saving for retirement, including the differences between pre-tax and after-tax accounts, visit the Protective Learning Center.