What is tax deferral and is it a good thing? The definition is very straightforward. Tax deferral is simply a legally acceptable way of putting off paying taxes. That’s the easy part.
What makes tax deferral so darn powerful?
You invest to get a return on your money – to make a profit. Sometimes the “return” comes in the form of interest or dividends. Other times the return comes in the form of increases in value otherwise referred to as capital gains.
Either way, at some point the government will tax that profit. And they’ll tax it no matter how you earned it. It doesn’t matter if it’s interest, dividends or capital gains. The only question is really what the tax rate will be and when the government will levy the tax. With me so far? Good, let’s continue.
When you open an account other than a retirement account, this is referred to as a non-qualified account. (Remember that you should never open an account in your name alone unless it is a “qualified” or retirement account.)
Let’s keep this easy and assume you earn 4% on the money and you open the non-qualified account with $100,000. Let’s also assume that you are in the 30% tax bracket. In the first year you’ll earn 4%, or $4,000. But is your balance $104,000? No, it isn’t. That’s because the government took $1,200 away from you (that’s 30% of $4,000). So at the end of the first year, you’ll have a cool $102,800 in your account. At the end of 30 years, you’ll be a little shy of $230,000, assuming all things are equal. (See the chart below.)
Now, let’s see what happens to your account if you make the exact same investment in a tax-deferred account. Again, this is an account that will allow you to continue NOT paying any income tax on the interest until you start withdrawing the interest. In this example, you again invest $100,000 and earn 4%. At the end of the first year you’ll have $104,000. Now, if you withdraw that entire $4,000 in the first year, you’ll pay a tax of $1,200, so you won’t have accomplished anything. And this illustrates the first rule of tax deferral. It’s only powerful if you give it lots of time.
Let’s see what happens to your tax-deferred investment after 30 years. In this case, your value grows to $324,000, which is significantly more than what the investment grew to in a taxable account.
Now, let’s say that after 30 years, you want to create income from this investment. Let’s assume that you continue earning 4% and, to keep things simple, let’s assume that you only withdraw this amount. You can see that in the taxable account your net spendable income is $6,668 each year.
In the tax-deferred account, you’re net income is $9,081. Yes, you paid income taxes in both cases, but with the tax-deferred account your income was about 40% greater.
Non Tax-Deferred Tax Deferred Account Account Value $100000 $100000 Interest $4000 $4000 Tax $1200 0 Value in 30 Years $229000 $324000 Gross Income 30 Years $9526 $12973 Net Income 30 Years $6668 $9081
And this, good Pilgrim, illustrates the second rule of tax deferral. Tax deferral is a powerful way to increase your retirement income. While tax deferral does help you grow your assets quicker, that isn’t the point. Having a bunch of money is nice, but having significantly greater retirement income is really what this is all about and actually much more important. Now that you know what tax deferral is and that it is a very good thing, there are a few conclusions I want to bring your attention to:
1. Time.
Since retirement accounts are, by nature, tax-deferred, it makes sense to focus your savings and investments in maximizing these investments for as long as possible. This will help you generate much greater retirement income when the time comes. You do this by maximizing your contributions to retirement accounts.
2. Beware of tax-deferred annuities.
Even though we just saw the potent benefits of long-term tax deferral, annuities are typically not a good idea. That’s because the insurance companies rope you in with attractive rates at first and typically drop them like a rock after the first year. Of course they’ll slap you with huge penalties if you try to take your money out of the annuity, so in many cases you’re stuck with a terrible investment. Sure, it has tax deferral and that’s great. But the return is usually very low and you won’t be able to do anything about it. And the tax deferral will not make up for the terrible interest rate the annuity will pay. Just forget it. In most cases, tax-deferred annuities stink.
3. Tax deferral is all about long-term planning and long-term income.
If you can’t plan for many decades ahead or you don’t care about income over many many years, tax deferral is of limited value to you. This is the reason I encourage all my readers to create a financial plan for themselves.
Do you contribute to tax-deferred accounts? Have you noticed other benefits of making such investments? Are there any drawbacks?
Mike says
April 23, 2012 at 10:54 AMHi, Neal. Are some of the numbers in your table reversed? From the above example, I thought the value of the tax-deferred $100,000 investment would be $324,000 and the net income would be $9,081 after 30 years. However, on the table these numbers are reversed with the non-deferred account.
It was just a little confusing because the table was going against everything you said in the paragraph that preceded it.
Neal Frankle says
April 23, 2012 at 11:14 AMMike. You are right! Thanks. I made the correction!
Neal
Optimus Thomas says
January 12, 2012 at 10:49 PMI agree it was a great article. I also agree that Traditional IRA’s and 401K accounts are great examples of tax deferred accounts.
The balance of these account grow tax deferred which means that the tax payment is due upon withdrawal which is usually at retirement.
There is a lot of debate as to which accounts are ultimately better- a Traditional IRA, a tax deferred account or a Roth IRA or taxable accounts that allows tax –free withdrawals.
Neal Frankle says
January 12, 2012 at 11:06 PMI believe it is generally agreed that the Roth option is good for younger investors – if you believe the government won’t change the rules. A big if.
Also, w/regards to conversion, there are some cases where this makes sense. It certainly doesn’t if the taxpayer is paying those taxes from the retirement account.
Sun says
December 27, 2011 at 9:44 AM> Either way, at some point the government will tax that profit.
This I understand.
What I don’t understand is why the Suze Orman and Dave Ramsey both recommend maxing out Roth IRAs before pre-tax retirement accounts.
Neal Frankle says
December 27, 2011 at 9:57 AMWell…for very young people maxing out the Roth can be a good idea. This is especially so if tax rates rise (and stay up there) into retirement. Of course, nobody knows what rates are going to be. Again, the younger you are, the better this works.