There’s only three things in life you can count on with absolute certainty. You’ll always have to pay taxes, death can’t be avoided and the Cubs will never win a World Series.
We can’t do anything about the last two items but thankfully, we can ease the pain of our tax burden by managing money properly and taking advantage of tax deferral when it’s available to us.
By using the power of tax deferral, you can significantly affect your retirement income and create wealth that is not otherwise possible.
What Does Tax Deferral Mean?
The definition of tax deferral is easy enough for anyone to understand. We are simply putting off tomorrow what we would normally pay today. While the net amount of taxes should be the same, the time value of money means that you’ll save significantly by paying this amount years later instead of right now.
What Makes Tax Deferral So Great?
The government is going to get theirs one way or another. Whatever form your money is in doesn’t matter, be it interest, dividends or capital gains. The two factors that come in to play are when the government will tax your money and what the tax rate will be.
Any account you open (outside of a retirement account) is considered a “non-qualified account”. Let’s consider an example of opening a non-qualified account with $100,000. Like most Americans, you probably fall in the 30% tax range and you might yield a 5% return in the first year. That’s $5,000 but it certainly doesn’t mean you have $105,000. You have to pay a $1500 tax to Uncle Sam (30% of $5,000), leaving you with $103,500 after that first year. After 30 years, you’ll have a little less than $140,000.
Let’s put this same money into a tax-deferred account. The power of tax deferral means leaving your money alone to accumulate interest. If you draw your $5,000 interest out after the first year, you’re paying the $1500 tax right away and have accomplished nothing. If you let it grow the entire time, your nest egg will grow to a whopping $360,000. You get the interest benefit of all that money that hasn’t been taxed over the years.
The chart below is another example of a tax deferred account in action.
Tax deferred accounts are primarily about retirement. Let these accounts mature and don’t even consider dipping into them for anything less than a dire emergency.
Should I Consider a Tax Deferred Annuity?
It’s best to stay away from a tax deferred annuity. These long term accounts look attractive but the appeal comes from attractive first year rates. After the initial year, those same rates typically dive down tremendously and you’re no longer making money.
Thinking of pulling your money out at this point? You’ll pay a hefty penalty so you lose either way. Having a tax deferred account does little good when the interest rate takes a nose-dive and your money is tied up and not earning.
On a positive note, you’ll still be able to afford those Cubs tickets.