What Does Tax Deferred Mean
It goes without saying that nobody is a fan of paying taxes, and if given a choice, most people would hold off forking over the money for as long as humanly possible. The good news is that there is a way to put off the inevitable, and you can even take advantage of substantial savings along the way; enter the popular concept of tax-deferral.
While you likely hear the phrase all the time and know that generally, it is a positive thing, do you really understand what it means?
Tax Deferred Definition
‘Tax-deferred’ refers to investment earnings on which income taxes and capital gains taxes are paid at a future date instead of the period they are incurred. These investment earnings include interest, dividends, or capital gains. Two of the most common examples of tax-deferred investments are retirement savings accounts and deferred annuities. (adapted from Investopedia)
Tax Deferred Meaning
Tax-deferred means that your investment growth is not subject to taxes immediately but instead will be taxed down the line. Upon retirement, most people will be in a lower tax bracket, meaning their savings will be subject to fewer income taxes.
The main benefit that this concept offers is the potential for tax-free growth through tax-deferred investments. The longer your funds remain invested, the more growth they will experience, offering substantial tax savings for investments held until retirement. You can also deduct your retirement savings contributions from your current year’s income, reducing the immediate taxes you owe.
The most popular method of deferring taxes is by contributing funds to a retirement account. 401Ks, traditional IRAs, and variations of these accounts are all tax-deferral options that you can utilize. Deferred annuities and employee stock ownership plans are also tax-deferred investments that can be leveraged to your advantage.
Deferred Tax Definition Example
A numerical example is an excellent way to demonstrate how powerful tax deferral can be over time.
Let’s assume Kurt had a $100,000 balance in an IRA in 2020, and the account earns 10%, resulting in a gain of $10,000. Since the funds are inside the IRA, a tax-deferred investment, they are not subject to taxes, and Kurt gets to keep the entire $10,000 gain. Kurt’s IRA account balance is now $110,000, and this new total will now experience compounded growth during 2021 and all subsequent years. With time, the advantage of tax deferral compounds results in a significantly higher balance.
Alternatively, without the shelter of a tax-deferral strategy and assuming Kurt was in a 33% tax bracket, he would have to pay $3,333 in taxes on the $10,000 capital gain, leaving only $6,667 in the account. The opportunity for compounded growth in future years would also be reduced.
Many people associate tax planning with a higher income and individuals or companies who try to avoid steep tax bills. When really, tax considerations should be part of any comprehensive retirement plan. Understanding how to incorporate tax deferral strategies into your overall financial plan is crucial for ensuring your investments maximize their potential.
Creative Financial Group works with clients to develop a customized retirement strategy catered to their current fiscal position and goals for retirement. Our knowledge and expertise surrounding tax deferral strategies and products ensure that our clients retain the maximum amount of their hard-earned money possible. Reach out to our professional team today to find out how we can assist.
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