A tax-deferred account is a type of financial account where you pay taxes on withdrawals at some point in the future instead of the year you earn the money. Delaying your income taxes to the future is beneficial in several ways. The government gives us a handful of useful accounts to take advantage. Follow along to learn more about how tax-deferred accounts work, where you can find them, and what to look out for when using tax-deferred accounts.
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How to Defer Taxes
With a tax-deferred account, you don't pay income tax the year you earn the funds. Instead, you pay tax on withdrawals in the future. This is a big advantage because you can save and grow your investments tax-free.
This gives you a bigger savings rate and encourages saving more, both good things! Considering inflation and the shrinking value of the dollar over time, when you pay your taxes in the future, you'll end up with dollars that are worth less than today's dollars. That is another benefit to you in taking advantage of tax-deferred accounts.
Tax-deferred accounts may also help you save on total taxes over time. If you were to pay tax at your regular income tax rate today, you will probably pay a higher tax rate than you would in the future. During retirement, you will likely have a lower income and lower tax rate than you do today.
When you add up those three main benefits — a lower future tax rate, inflation and having more to invest with today — a tax-deferred account is a powerful way for you to save on tax and grow your wealth. In the next three sections, we will talk about three of the most popular types of tax-deferred accounts.
What Are the Best Tax-deferred Investments?
For a considerable number of people, the first place you will ever invest is an employer-sponsored retirement account. The most popular version is the 401(k), though some education and government employees may find a 403(b) or 457 plan at work instead.
In any case, these are great ways to save for retirement. And if you work for a large company, you may also have access to employer 401(k) matching. If you get any kind of retirement contribution matching, take full advantage. It is often a 50% increase in your savings amount. Skipping your match is like leaving free money on the table!
With a 401(k) and similar accounts, contributions are typically automatic every payday. You can contribute to this type of account up to an IRS-imposed limit: $19,000 per year for 2019. Once your funds are in the account, you can invest and watch the account value grow until you reach retirement.
Once you reach age 59½, you can start to withdraw from the account without any penalties. You pay regular income tax on withdrawals, but you are withdrawing from an account that is a lot bigger than it would be without tax-deferred status.
A traditional IRA (individual retirement account) is a type of retirement account you can open outside of your employer. An IRA is available at most major brokerages and even many banks.
With a traditional IRA, you can contribute up to the annual limit, $6,000 for 2019, with a tax-deferred status. There are some income limits with an IRA. Your maximum contribution begins to shrink at an income of $122,000 per year for a single filer or $193,000 per year when married and filing jointly.
A Roth IRA is another great tax-advantaged account for retirement, but it is not tax-deferred. Instead, taxes are paid up front, and withdrawals in the future are tax-free. This makes a Roth ideal for younger people and those with a long time horizon before retirement. We recommend Wealthfront to handle your IRA.
Health Savings Account
The best tax-advantaged account available is arguably the health savings account (HSA). This account is tax-deferred in a way. You could actually argue that the account is tax-free, as neither contributions nor withdrawals are taxed.
HSA accounts are available only to those with a high-deductible health plan (HDHP). This type of account also typically can't be used in conjunction with a flexible spending account (FSA). But if you are able to take advantage, an HSA may be the best type of retirement account available!
While you can reimburse yourself for qualifying medical expenses right away when you have an HSA, you can wait to reimburse yourself at any point in the future. If you wait until retirement, you can withdraw for any previous medical expense tax-free. And meanwhile, your investments will likely grow. That's amazing for your money!
Early Withdrawals Are Expensive
One major consideration when contributing to a tax-deferred account is what happens if you need the money early. If you withdraw from a tax-deferred account before retirement or other qualifying conditions are met, you'll have to pay both tax and a penalty on the withdrawal.
In most cases, withdrawing from a traditional IRA before you are 59½ years old requires income tax plus a 10% penalty. The same is true of a 401(k). Don't throw away hard earned savings by withdrawing early unless it is absolutely necessary.
In some cases, you can take a loan against funds in your retirement account, but if you don't pay them back, you will be on the hook for the same taxes and penalties described above. This is why retirement planning is important. If you under-save, you will run out of money in the future. If you over-save, you could get stuck paying early withdrawal penalties. Try to find the sweet spot where you meet your needs without going over what you can afford.
Take Advantage of Tax-deferred Accounts to Save Big on Taxes
When it comes to tax-deferred accounts, you should save as much as you can comfortably afford. Most experts suggest you need to save at least 10% to 15% of your gross income (that's before taxes and deductions) to maintain the same standard of living in retirement.
Tax-deferred accounts make it a lot easier and can save you money along the way. To guarantee yourself a comfortable retirement, get to work saving in your favorite tax-deferred account.
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