Deferring taxes is a strategy for keeping more money in your pocket. Regardless of the stage of your life or career, you’ll have concerns about your taxes.
Maybe you typically get a refund from the IRS, but this year — for some reason — you owe taxes. Or maybe you bought or sold a home during the tax year. How will that affect your annual tax return?
Questions abound when it comes to the tax code. Some answers are more complicated than others, but understanding how tax deferral can boost your retirement savings is a good start to developing a tax strategy.
What Is Tax Deferral?
To clarify: tax-deferred does not mean tax-free.
All qualified retirement plans allow taxpayers to defer taxes on contributions and earnings. Qualified annuities also provide the benefit of delaying taxes. In all cases, tax deferral is a powerful incentive for people to include these tax-favored vehicles as part of their retirement plan.
The benefits of tax deferral are maximized on long-term savings products, such as annuities with lengthy accumulation periods. The longer time horizon allows for the compounding of interest, which means that the contract owner not only saves more in taxes, but also accumulates more by earning interest on interest, with no taxes due until they begin receiving income payments.
Tax deferral applies to the premiums and earnings on qualified annuities because the products are purchased with pre-tax dollars. The same goes for qualified retirement plans, to which taxpayers contribute pre-tax funds. Tax deferral for nonqualified annuities, which are purchased with after-tax funds, applies only to the earnings.
The income benefits from annuities and retirement plans are taxed accordingly in the year during which the taxpayer receives them. Note that the IRS calculates the taxes on distributions from qualified annuities using the exclusion ratio. Also known as “the general rule,” the exclusion ratio ensures that only the taxable portion of the payments are included in the annuity owners gross income for the year.
Qualified annuities are purchased with pre-tax money.
Nonqualified annuities are purchased with post-tax money.
Understanding how tax deferral impacts your financial portfolio can help you maximize your savings.
What Are the Benefits of Tax Deferral?
The primary benefit of tax deferral is the growth achieved through compounding interest.
As opposed to money market mutual funds, brokerage accounts, and similar financial instruments on which you pay an annual tax on earnings, tax-deferred products allow the full amount of the earned interest to remain in the account and continue to earn interest, which in turn, will not be taxed. And so on until you start taking distributions.
Tax-deferred compound interest can increase the value of an annuity or retirement plan over time.
It’s likely that you’ll be in a lower tax bracket during retirement years, when you have less taxable income and a higher standard deduction than you had during your working years.
For example, the tax code states that only people who “have other substantial income in addition to your benefits (such as wages, self-employment, interest, dividends and other taxable income that must be reported on your tax return)” owe federal income tax on their Social Security benefits.
You may also decide to retire to a tax-friendly state to reduce your tax burden.
Types of Tax-Deferred Products & Retirement Accounts
The IRS has varying rules for the different types of tax-deferred products, but you can create a proactive savings strategy by understanding your tax responsibilities.
Your employment status, financial goals, investment portfolio and level of financial literacy all play a role in determining which type of tax-deferred retirement plan you are eligible for or which type of annuity you should purchase.
For example, a 35-year-old man may work for a business that does not offer a 401(k) plan, so he may choose to contribute to an IRA to achieve his financial goals. A self-employed woman who meets the criteria for establishing a SEP IRA may find the annual contribution limits too restrictive and opt instead to purchase a $100,000 annuity.
Annuities are tax-deferred risk-transfer products that provide the contract owner with a guaranteed income stream in retirement. Annuities may be purchased with either pre-tax or after-tax dollars and the taxable portions of any distributions are taxed as ordinary income, not capital gains.
Annuities purchased with pre-tax dollars are referred to as qualified annuities. Because taxes have been deferred on all qualified annuity funds and earnings, the full amount of distributions are taxable. For nonqualified annuities, the exclusion ratio determines the taxable portion of withdrawals.
According to FINRA.org, “Unlike other retirement accounts that offer tax-deferred growth, like IRAs and 401(k)s, annuities don’t have annual contribution limits. That means you may be able to sock away more money with an annuity than you would with those other plans.”
Grow Your Money With an Annuity
Employer-Sponsored Retirement Plans
Employers often provide defined contribution plans and defined benefit plans as retirement-savings options. It is important for employees to take retirement-related benefits into consideration when they evaluate one employer’s full compensation package over another’s. Not only are there differences in plans, but some employers may contribute more than others. And yet others offer no retirement plan at all.
- 401(k) Plan
- Funded by pre-tax payroll deductions, 401(k) plans can include contributions, or matching, from an employer in the for-profit sector.
- 403(b) Plan
- Funded by pre-tax payroll deductions, 403(b) plans can include contributions, or matching, from nonprofit employers.
- 457 Plan
- Local and state government agencies and some nonprofit organizations offer 457 plans.
- SEP IRA
- Self-employed taxpayers and small businesses may establish SEP IRA plans.
- SIMPLE IRA
- Employers with fewer than 100 employees may offer SIMPLE IRA plans.
- Pensions are employer-specified and provided retirement income, often without employee contributions.
Types of Employer-Sponsored Retirement Plans
Source: Internal Revenue Service
Regardless of the type of retirement plan offered, it’s always advisable to contribute the maximum amount. Your employer can connect you with a financial professional who can help you develop a strategy for allocating your assets and maximizing your savings.
Individual Retirement Accounts
As an alternative or in addition to contributing to an employer-sponsored retirement plan, you can set up an individual retirement account (IRA). Depending on the type of IRA, your funds can grow tax-deferred or tax-free.
Traditional IRAs allow you to contribute pre-tax dollars, or income that has not yet been taxed. Contributions and earnings grow tax-deferred, so they are taxable only in the year they are withdrawn.
Contributions to Roth IRAs are made with after-tax funds. Earnings grow tax-free, rather than tax-deferred. This means that qualified distributions, or earnings you withdraw that meet IRS requirements, are not taxed as income after retirement.
The IRS poses limits on contributions for both traditional and Roth IRAs, and a 10 percent penalty may apply if you withdraw funds from either type of account before you turn 59 ½ years old.
Health Savings Accounts
Health savings accounts (HSAs) allow you to set aside pre-tax dollars to be used for qualified health-related expenses. According to HealthCare.gov, “By using untaxed dollars in a Health Savings Account (HSA) to pay for deductibles, copayments, coinsurance, and some other expenses, you may be able to lower your overall health care costs.”
For example, if you contribute $50 per paycheck directly into an HSA, you would not have to pay income taxes on the $50. The balance in the HSA will continue to grow tax-free, while your taxable income would decrease by $50 each paycheck.
Saving money on income taxes now can allow you to save more for retirement.
Effective planning and leveraging opportunities to defer taxes can lessen the burden of what FINRA says can be “your single largest expense in retirement.”
Although tax deferral does not eliminate your tax liability, tax-deferred options can help you save — and earn — more per dollar.