Last week we discussed when to contribute to a Roth account. This week we will look at the counter part… tax deferred accounts. These are known as Traditional IRA, 401(k), 403(b), SIMPLE IRA, and SEP to name a few popular versions.
As you can see, there are many more tax-deferred account options than Roth options.
To contribute to any of these tax sheltered retirement accounts you must have earned income. Without earned income such as wages or business income you’re not allowed to contribute to these accounts.
When you contribute to a tax deferred account it goes in tax free. When the money comes out it is taxable income.
These are the most widely used accounts available, but knowing why to select a tax deferred account over a Roth account is important.
What is a tax deferred account?
As stated to in the intro, a tax deferred account is:
- A retirement savings account…
- Where contributions in are a tax deduction now.
- When you take money out, the money is considered taxable income.
Point number two is what creates a tax shelter for your money. You will pay social security and Medicare on that money before it enters that account, but you will not pay income tax on that money.
Like a Roth account the money invested inside the account will grow tax free. As you earn interest, dividends, or capital gains on the money, you don’t pay tax on growth.
A tax deferred account could also be called a Tax-Free Contribution Accounts.
Example: You invested $100 into a Tax-Free Contribution Accounts. It grows to $1,000. You have $900 of growth and $100 on principal. When you decide to take the full $1,000 out of the account all of that money is subject to tax. If you are in the 25% tax bracket then you keep $750 after federal taxes. Less if you have a state with income tax.
Important to note is that unless you meet a hardship withdrawal requirement or other exceptions, you cannot access this money until you are 59 1/2 or older without paying a 10% penalty. Another important requirement to note is that you must begin Required Minimum Distributions at 70 1/2, which minimizes the length of time you can let your account grow tax deferred.
When should I contribute to a tax deferred account?
The general rule of thumb is that you should contribute to a tax deferred account during your high income tax years. Generally during your working years you will have higher income taxes than you will in retirement.
Example: Jon, a manager is in the 25% tax bracket as an employee. When Jon retires he anticipates that he will be in the 15% tax bracket. By Jon contributing $1,000 to a tax deferred retirement account he will save $250. If Jon’s $1,000 didn’t appreciate in value and he withdrew the $1,000 in retirement it would cost him $150 in taxes. Therefore, Jon’s $1,000 contribution is actually worth $1,100 (i.e. $1,000+$250-$150). Jon wins.
Because it’s impossible to know your future tax rate you are left making your best guess. You can run some numbers with your favorite financial calculator or work with a trusted advisor to get a better idea of what your nest egg will pay you in retirement.
Ultimately, if you aren’t sure… flip a coin and just go with one! Making a decision is better than not making a decision. The only sure way to lose in this decision is to not make a contribution to any account.
Why tax deferred accounts are the best
As stated above, you want to utilize a tax deferred account when you expect to be in a lower tax bracket when you take the money out.
Being closer to retirement makes this much easier. If you are 5-10 years from retirement you can have a good sense of what the current tax rate environment is like.
For most people this means you need to be 50-60 years old. However, there is a certain set of the population who is committed to saving for early financial independence.
This crowd saves a high percentage of their income and can reach financial independence within 15 years of working. This crowd benefits a great deal from utilizing a tax deferred account.
Why? Because their cost of living is significantly smaller than their earnings, which means by establishing significant tax deferral strategies plays perfectly for early financial independence.
Basically, by having large earnings now and lower income needed later, the path to early financial independence is a perfect match for tax deferral. In fact, this might be the best group to utilize maximum tax deferral strategies. It’s almost like the tax code is made for early financial independence!
As always talk with a qualified tax advisor to determine what is best for your specific situation.
Do you want to understand how to make your money work for you and keep more of what you have earned?
Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Nate Byers a Madison, WI CPA Financial Advisor, and all rights are reserved. Read the full Disclaimer in the footer below.