Retirement Planning

Understanding Tax Deferral

When you're planning for retirement, you hear a lot about tax-deferred accounts and compounding interest. But what exactly does that mean? Find out here.

Retirement Accounts: What Does Tax Deferred Mean and What Are The Advantages?

The term tax-deferred simply means that you'll pay taxes at a later date. Investment accounts that are considered tax deferred typically include traditional and Roth IRAs, SEP IRAs, and 401ks. In addition, many insurance company products, such as deferred annuities and certain life insurance policies, may also provide tax-deferred benefits.

The power of compounding

When it comes to retirement planning, retirement accounts that are tax-deferred can have a big impact on your retirement savings, by allowing your money to grow quicker than if it were in a taxable investment account. How? With a process called compounding.

In the context of tax deferral, compounding allows for interest and dividend payments to be unencumbered by taxes until withdrawn at a later date.  Ideally, this occurs years in the future. This can allow for more efficient growth of your contributions than would have been experienced had those same dividend and interest payments been subject to tax at the time they were originally received.

Moreover, contributions in your tax-deferred accounts are often made when you're earning a higher income and typically subject to a higher tax rate. So when it comes time to retire and begin drawing 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.

For more information on improving your retirement planning knowhow, visit the Protective Learning Center.

Disclaimer: The information in this article is not intended to be tax or legal advice and should not be relied on for the purpose of avoiding any federal tax penalties. Please consult with a qualified tax professional or consult with a professional financial advisor.

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