If you're investing for retirement, you might consider cultivating a tax-deferred plan.
To provide a source of retirement income you can draw on after you stop working, you have to invest for retirement while you're still on the job. To take advantage of the opportunity to accumulate tax-deferred earnings and in some cases defer taxes on your contributions as well, you can participate in employer-sponsored retirement plans and invest in individual retirement accounts (IRAs) that you set up on your own. In fact, you can do both at the same time.
TYPES OF PLANS
You may participate in an employer-funded retirement plan or in an employer plan to which you make contributions by deferring a portion of your salary. Both types offer tax advantages. The major difference is the source of the money that's invested — whether your employer puts it in, over and above your salary, or a portion of what you earn. You may participate in several different plans, either at the same time or at different points in your working life.
Profit-sharing and money purchase plans are funded by your employer, with money that's separate from your salary. Your employer gets to deduct the contribution from corporate income tax. In some cases, if you own a small business, you may set up such a plan even if you have just one or two employees.
Retirement savings plans are funded with a portion of your earnings. In a traditional plan, the amount of your contribution is subtracted from the amount reported as income to the IRS, decreasing the amount on which you owe current taxes. Many employers also contribute to your retirement savings plan, often a percentage of your contribution up to a fixed cap.
If your employer offers a Roth 401(k) or Roth 403(b) in addition to a traditional 401(k) or 403(b), and you choose to participate, your contribution is made with after-tax income. Both accumulate tax-deferred earnings, but when you withdraw from either of these Roth accounts, the amount is exempt from federal income tax provided you are at least 59 1/2 and your account has been open at least five years. If your employer contributes, that money goes into a separate traditional account.
In all cases, your account value and the retirement income it provides will depend on the amount that is invested, how it is invested, and how well those investments perform over time. Since investment returns aren't fixed and will fluctuate, you may have gains in some periods but losses in others.
A QUALIFIED ADVANTAGE
When you contribute pretax income to a retirement plan, you postpone or defer paying taxes on your contributions and on any investment earnings until you begin to withdraw the money. When you invest through a taxable account, earnings are taxed at the rate that applies to dividends, interest, and capital gains even if you reinvest those earnings. Remember that earnings are not guaranteed in either type of account.
WHAT'S TAX DEFERRED?
While you'll hear a lot of discussion about tax-deferred investments as a way to save for retirement, it's actually the accounts or plans you use to save, not the specific investments you hold in those accounts or plans, that are tax deferred. Any earnings you accumulate on money in those accounts or plans are also tax-deferred. That's why an investment, such as a mutual fund, produces tax-deferred earnings if you purchase shares with money you put in an IRA but taxable earnings if you hold that mutual fund in a taxable account.
DOES TAX DEFERRAL PAY?You pay income tax on the money you withdraw from your traditional tax-deferred account at whatever your tax rate is for the year you withdraw the money. For example, if your taxable income, including the amounts you withdraw, puts you in the 28% federal tax bracket, that's the top rate at which you pay tax and the rate that will apply to your withdrawal amount.
You may wonder if you'll end up owing more tax on the money you eventually take out of your tax-deferred account than you would have paid at the time you actually earned the money. Realistically, there is no way to tell for sure. Tax rates change over time, depending on a number of factors. What you earn changes as well.
But because you owe no tax during the years your account accumulates earnings, tax-deferred accounts have the potential to grow larger than a comparable taxable account, especially if you have to withdraw from the account to pay the taxes that are due.
You may have an alternative, though, if you can contribute to a Roth 401(k), Roth 403(b), or Roth IRA. Then you pay taxes on the money you contribute but will be eligible for tax-free withdrawals when you retire. Using a combination of traditional and Roth accounts lets you take advantage of both approaches.
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