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When it comes to investing, it’s critical to consider how taxes might impact your earnings. Luckily, there are tax-efficient investment strategies that allow your money to grow and compound without the immediate drag of taxes.
Think of tax-deferred investments as the cruise control feature in your car, designed to optimize efficiency during a long journey, such as saving for retirement. Without unnecessarily accelerating and breaking (taxes), your vehicle preserves fuel (money), allowing you to cover more ground (earnings).
In this article, we’ll explore the type of tax-deferred accounts available and how you can start investing in them.
What is a tax-deferred investment account?
Since the introduction of the Individual Retirement Account (IRA) in 1974, the U.S. government has passed legislation letting individuals contribute to tax-advantaged accounts. These accounts motivate people to save for their retirement, so they aren’t solely reliant on government-funded programs like Social Security.
In essence, contributions to tax-deferred accounts allow you to postpone paying taxes until you begin making withdrawals. At that point, the government taxes your earnings as ordinary income.Tax-deferred accounts have two main advantages. First, they help you lower your annual taxable income. Second, your investments grow tax-free until you begin withdrawing the funds. (There are other benefits, too.)
That’s why most financial professionals encourage investors to max out their contributions, especially if you are in a high tax bracket and expect to pay lower taxes in the future.
Types of tax-deferred investment accounts
There are several types of tax-deferred investment accounts, each with their own benefits and eligibility criteria. Here are a few examples:
- Traditional IRAs: Tax-advantaged retirement accounts where contributions may be tax-deductible, and growth is tax-deferred until withdrawal.
- Retirement plans like 401(k) and 403(b): Employer-sponsored savings accounts for retirement, often with company matches and tax advantages.
- Fixed deferred annuities: Insurance-based contracts offering guaranteed interest rates for future retirement income.
- Variable annuities: Insurance contracts tied to investments, offering potential growth but with market-related risks.
- I Bonds or EE Bonds: U.S. government savings bonds with low risk and tax benefits.
- Whole life insurance: Permanent life insurance with a tax-free benefit for beneficiaries and a cash-saving component that the policyholder can access or borrow against.
Through tax-deferred accounts like an IRA or a 401(k), you can invest in stocks, exchange-traded funds (ETFs), mutual funds, bonds, certificates of deposit (CDs) and other assets.
What are the drawbacks of investing in tax-deferred accounts?
There are different rules and restrictions for investing in tax-deferred accounts. Consulting with an investment advisor or tax professional is important to ensure you’re making the best decision for your financial situation and goals.
A few of the trade-offs include:
- Contribution caps: Each year, the Internal Revenue Service establishes limits on how much you can save in tax-deferred accounts. The maximum contribution to a 401(k) plan in 2023 is $22,500, while the limit for IRA contributions is $6,500. (Those limits are higher for people 50 and over.)
- Penalties on early withdrawals: Taking money early from tax-deferred accounts comes at a cost. There’s a 10 percent penalty if you withdraw funds from your 401(k) plan or IRA before age 59½. You’ll also owe taxes on the amount withdrawn. Although there are exceptions, it’s usually not a good idea to touch your savings in these accounts.
- Required withdrawals: Even though your money has grown tax-free, you will have to pay taxes on it eventually. This is the case for retirement accounts like an IRA or 401(k), which require minimum distributions (RMD) starting at the age of 72 or 73. Missing or skipping an RMD can result in significant tax penalties.
While the terms and conditions for tax-deferred accounts can be complex, the benefits can be substantial. By strategically using these accounts to postpone taxes, you can optimize your wealth-building potential, allowing your investments to compound and grow over time. Just make sure you understand the tradeoffs. Consult a professional for advice specific to your circumstance.