What you need to know about Tax-Deferred Investments
Hi everyone, and welcome back to Melissa Making Cents!
As a CERTIFIED FINANCIAL PLANNER™, I sometimes use words and phrases that are commonplace in finance that may not be as easily understood by someone who doesn't do the same kind of work that I do. In fact, lately, I've been using a word/phrase quite a bit in various posts that I feel deserves a bit more attention than it's been getting. Not only will the understanding of this phrase broaden your understanding of financial principles, but it can open up an entirely new world for those who are serious about saving money and growing their wealth for their family's future!
Being a financial coach, I feel that it is my duty and my responsibility to inform and educate those around me. Not every article or post that I make necessarily needs to be about the latest financial trend or stocks and bonds; sometimes, it's just best to cover the basics! That's why today we'll be talking about the phrase Tax Deferred!
Tax-Deferred - The Meaning
What is Tax-Deferred? Tax-Deferred is an adjective phrase that's used to describe an account. Specifically, it describes how the account deals with taxes! While with many types of investment accounts, you'll need to immediately pay taxes on your financial gains, that isn't the case with a tax-deferred account. Instead, you'll be accumulating wealth and won't have to worry about paying taxes until you begin withdrawing the money that you've waited so patiently to tap into!
What Types of Accounts are Tax-Deferred?
There are a few different types of tax-deferred accounts that investors will love! Chances are you've heard of a lot of them but just haven't quite figured out what they are! So let's quickly discuss some of these accounts and briefly brush up on our knowledge of them!
Before we start, you'll notice a common theme with tax-deferred accounts… they're typically geared towards helping save and invest for retirement! If you think about it, this actually makes perfect sense. This tax advantage is perfect for long-term saving and investing, and the government wants to incentivize people to prepare for retirement.
A 401k is, of course, a type of retirement account. These are typically offered by employers; however, there are some situations where that may not be the case. Perhaps the most notable thing about 401k's and why they're so attractive is that 1, they're tax-deferred, and 2, they usually come with some sort of matching incentive from your employer.
The combination of being tax-deferred and having an employer match your contributions is a great way to boost your retirement savings! But, as is the case with many things, the devil is in the details. 401k employee matching isn't always dollar for dollar, and employers will most likely limit the amount they're willing to match to your contribution. Either way, a 401k is an excellent tax-deferred option for those to whom it's available.
All hope is not lost for those who don't have the luxurious option of an employer-matched 401k! As another way to incentivize Americans to save towards retirement, the government created the Individual Retirement Account, more commonly referred to as an IRA. IRAs come in a few different forms, so we're talking about the traditional IRA for specificity.
A traditional IRA is tax-deferred, but the hook is that you can't rely on an employer to create and maintain this type of account. The 401k mentioned above is not mandatory, so if your employer doesn't offer one or if you're self-employed, an IRA is a fantastic way to begin saving towards your retirement.
Other accounts, or vehicles, also enjoy the tax-deferred status, but these are the two that are at the forefront of most people's minds. Accounts like these don't just hold money with a small annual interest rate; they hold all sorts of things. Stocks, bonds, mutual funds, ETFs, and other investments are all assets you may put in one of your tax-deferred savings/investing accounts.
Is Tax-Deferred Best?
Obviously, you always want to know what's best! And why shouldn't you?! This is money that you're putting away towards your golden years, money that you'll be able to use to travel the world and spoil your children and grandchildren (or yourself) with.
Taxes… what this is all about. That's essentially what will be the deciding factor in what is or isn't best when it comes to deciding whether or not to use a tax-deferred retirement plan. If you look into your crystal ball and believe that your tax bracket in the future will be lower, tax-deferred is the way to go. However, if your tax bracket in the future is higher, you're saving just to spend more on taxes in the long run than you initially would have. There is something else to keep in mind, and that's compounding interest. By initially not paying taxes and putting it off towards the future, you're maximizing the amount of money that will go into your investments, which will affect your compounding based returns and gains.
The shorter and more accurate answer to what's best is always going to be that it depends. Meeting with a financial advisor representative or financial planner who can look over your situation with a fine-toothed comb and use that information to make a custom-tailored financial plan that suits you, your family, and your income is always going to be better than taking a shot in the dark.
Contribution Limits, Required Minimum Distributions, and Age Limits OH MY!
Contribution limits are yet another thing to keep in mind when deciding what type of tax-deferred account is best for you or if a tax-deferred account is the right move at all! A contribution limit is just what it sounds like. It's a limit on the amount that you may contribute annually to your account. For some accounts, this limit will be lower, while for others, it will be higher. The rules and regulations of each type of retirement account vary. Obviously, there are differences between how 401k's, IRA's, and the all rest are all structured, and they have varying sets of rules to accommodate those structures.
Required Minimum Distributions and age limits work hand-in-hand. Essentially an age limit is the age to which you must wait before you're allowed to begin pulling money from your retirement account. If you don't wait long enough, you may be penalized for withdrawing money too early. Whereas if you wait too long, you'll also be punished.
Once you reach a certain age, you'll be required to start taking what is called a Required Minimum Distribution. A required minimum distribution is a minimum account that you must annually withdraw from your account and pay taxes on. This is the IRS's backup plan, so people don't get away with saving, investing, and avoiding paying taxes until the end of time.
Tax-Deferred accounts are a fantastic way for many to save and invest money toward their retirement. If you're interested in learning more about different strategies for a wonderful retirement or just learning more about tax-deferred accounts, please call or email to schedule an appointment with me. Together, we can create a financial plan that helps you plant the seeds to a fruitful future for you and your family!
Until next time...this is Melissa Making Cents!
Melissa Anne Cox, CERTIFIED FINANCIAL PLANNER™, is also a College Planning and Student Loan Advisor and Financial Coach in Dallas, Texas.