Investing in your future may not seem ideal when you have bills to pay now. At Royal Legal Solutions, we understand the ups and downs of daily finances. However, using a tax-deferred investment strategy can help ensure you can enjoy your golden years as you wish. Below, we take a look at the benefits associated with tax-deferred investments and some of the best ways to build your “nest egg”.
Tax Lingo You Should Know
“Tax-deferred” does not necessarily mean you will never pay taxes. Instead, it refers to investment earnings that accumulate free of taxes. These “tax-free” investments and their returns are only taxed once you make withdrawals. Depending on the plan you pick, you have the option of paying taxes before investing instead of later when you withdrawal. But we will talk about that more in a moment.
The Benefits of Tax Deferred Investments
There are two primary benefits when it comes to tax-deferred investments, both of which primarily revolve around saving you money and reducing taxes.
Invest Now, Pay Later
First, by paying taxes later, your investment returns are allowed unrestricted growth. This means that the money that would be taken by taxes, stays in your account. The more money in your account, the more you can invest. With more investments comes a higher potential return.
Potentially Lower Taxes
Second, most investments are initially made prior to retiring. In general, the taxes collected from your employment wages are much higher than those that are levied against your retirement earnings. By default, most Americans earn less during their retirement years than they did while working. Whether working part-time, holding easier jobs, or relying on their “nest egg” – retirees are not typically working high-dollar 9-to-5’s. By waiting to pay taxes on your investment gains, you can potentially owe less than you would if you were taxed upfront.
Types of Tax-Deferred Vehicles
So how can you jump onboard the tax-deferred train and start increasing your retirement fund? Most people jump on the bandwagon in one of three ways:
- Individual Retirement Accounts (IRAs); or
- Annuity Contracts.
Let’s take a closer look at the differences between these vehicles.
A 401(K) makes for a great long-term investment strategy. Often offered by employers, contributions are made on a pre-tax basis. This means, not only are you investing in your future, but you are also reducing your taxable income. Many employers will match your contribution as well, increasing your investment capital. (Check with your employer. Some may require a certain number of service years from you before they fully match your contributions. Others may have a cap for dollar-to-dollar matching.) There is a catch with 401(k)s. Withdrawals made before retirement will be subjected to higher taxes than they would be if made later as well as an IRS penalty tax. In addition, most 401(K) companies will treat your withdrawal as a loan; you will need to repay the funds should you take a withdrawal before retiring.
There are several kinds of IRAs available. Traditional IRAs tend to be a favorite of those grossing $200,000 or more annually. In fact, 64% of those with higher incomes have at least one traditional IRA. Contributions made to a traditional IRA are tax deductible in most cases. However, an early (or pre-retirement) distribution will subject you not only to higher taxes, but also to an additional penalty. Roth IRA contributions are made after taxes have been taken from your wages. As with traditional IRAs, your investments can grow tax-free. While post-retirement withdrawals are tax-free, the IRS makes a clear distinction when it comes to early disbursements. Your original contributions can be withdrawn at any time from a Roth IRA; distributions of earnings, however, are subject to income taxes and a 10% penalty tax. For those who elect to open a Self-Directed IRA (SDIRA), which can be either traditional or Roth, investments are also tax-deferred. Because you must have a custodian for a SDIRA even though you make your own investment decisions, make sure you hire a reputable investment professional who won’t take advantage of these specialized nature of these accounts. (Our investment professionals have years of experience.)
Deferred Annuity Contracts
An annuity contract is a deal between you, as the investor, and a life insurance company. In a deferred annuity contract, income payments from your investment are paid at an agreed upon future date, as either installments or a lump sum. There are two phases to a deferred annuity contract – the investment savings phase and an income phase. Deferred annuity contracts can have fixed or variable rates associated with them. Withdrawals from annuity contracts are a bit more complex than those of 401(K)s and IRAs. Annuity contracts are typically subject to a “surrender period”. Depending on the contract, investors may be required to wait many years before withdrawing money from their account. Should they pull money prior to the end of that period, they will have to pay a “surrender charge”. As with the 401(K)s and traditional IRAs, a 10% penalty is charged by the IRS if money is withdrawn before retirement and withdrawals are subjected to income tax rates.
Tax-Deferment and You
Tax-deferred investments are great for planning your retirement. Pre-tax deductions lower your taxable wages, giving you a bit of a savings upfront. By not paying taxes immediately on your investment returns, you are able to invest even more. This creates a potentially larger return as you approach retirement age. When you do make withdrawals during retirement, the taxes paid on them are lower as well. Whether helping you arrange annuity contracts or providing financial advice and investment support on your IRA, we are here to help.