For most of us, saving for retirement is done via some kind of employer-sponsored 401(k). We may also have an individual retirement account (IRA) of some kind. Traditionally, these are both tax deferred accounts, meaning you contribute the money income-tax free, and then pay taxes later when you withdraw it. Let’s take a closer look at how tax deferred accounts work, and the benefits associated with using them in retirement planning.
(Note: There are “Roth” versions of these accounts that function in a different way.)
The tax question
When your investments make money, it’s considered a capital gain, which falls under a different category than income from a job. Long-term capital gains (on investments you hold for more than a year) are taxed at a different rate than short-term capital gains. Short-term capital gains are actually taxed at your marginal tax rate, meaning the highest tax bracket of your income on a given year.
Consider as an example a 6-month CD. If your investment netted you $100, but your marginal tax rate is 30 percent that year, your real returns would be only $70, since you would lose $30 to taxes.
How tax-deferral works
Tax deferral is the process of delaying (but not necessarily eliminating) your taxes until a later date. With a retirement account, this means that when you withdraw the money from say a 401(k) as income in retirement, you’d pay federal income tax on that money. However, you won’t pay income tax on the money you contribute, and your money can grow tax free. This type of account is one of the best ways to accumulate funds for retirement. Tax deferral can be beneficial because:
- The money you would have spent on taxes remains invested
- You can accumulate more dollars in your accounts due to compounding
- You may be in a lower tax bracket when you’re ready to make withdrawals (for example, when you’re retired)
Compounding means that your earnings become part of your underlying investment, and they in turn earn interest. (In the earlier example, you’d be able to reinvest the full $100 from the CD, versus just $70.) The benefit of compounding can be dramatic for investors with a long time frame.
Contributions for 2015 to the following types of plans grow tax deferred, but you’ll owe income taxes when you make a withdrawal.
Roth accounts (tax me now)
With Roth IRAs, or Roth 401(k)s, your money still grows tax-free, meaning you can still benefit from increased compounding. However, your contributions are made with after-tax dollars, then qualified distributions are tax free when you withdraw them in retirement. Roth IRAs are open only to individuals with incomes below certain limits.
The amount you can contribute each year is the same for both traditional and Roth plans and 401(k)s and IRAs. However, if you contribute to both accounts in the same year, both contributions count toward your annual limit.
Many financial sites promote tax-deferred accounts since they predict people’s income (and therefore tax bracket) will be lower in retirement. If true, this could lead to less tax paid overall. However, future tax rates can go higher or lower depending on a number of factors. So when it comes to my clients, I believe in tax diversification. Beyond tax rates, as you get older, things like inflation, health expense, and the deductibility of certain items can make you more financially vulnerable. It is wise to provide options for the future.
Finally, while taxes are important, your investment decisions shouldn’t be driven solely by tax considerations. You should factor in things like potential risk, the expected rate of return, and the quality of the investment. This issue is ripe for a collaboration between you, a tax professional, and a financial advisor.