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 IRAs, plans covering self-employed persons, and 401ks. In addition, many insurance-related vehicles, such as deferred annuities and certain life insurance contracts, 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.

According to Investopedia, the definition of compounding is the ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings.

The process of compounding simply allows your entire contribution (principal) and any additional earnings that you may have accumulated to earn interest. Essentially, you're earning interest on your interest. Over an extended period of time, the compounding effect can make a big different in the accumulation of your retirement nest egg - for the better!

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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All Learning Center articles are general summaries that can be used when considering your financial future at various life stages. The information presented is for educational purposes and is meant to supplement other information specific to your situation. It is not intended as investment advice and does not necessarily represent the opinion of Protective Life or its subsidiaries.

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Saving for Retirement

Saving for retirement can often feel as though you are mired in a bowl of alphabet soup with unfamiliar acronyms and terms. However, saving for retirement and learning more about retirement accounts and how they work, can help you make better decisions for your future. For more information, visit our learning center.