Tax Deferral — Postponing taxes to help your money grow
Tango with two tax breaks
Use retirement savings accounts to put off paying some of your income taxes.
- An immediate deduction — Contributions to a 401(k) or other employer-sponsored retirement plans, and to traditional IRAs, can reduce your taxable income dollar-for-dollar (up to certain IRS limits).1 This may lower your current federal income taxes. Instead of paying Uncle Sam, you’re investing the money where it has the opportunity to grow and generate income for you down the road.
- Long-term deferrals — Earnings in your retirement account aren’t taxed until you withdraw the money, which means 100 percent of your earnings get reinvested, year after year. This can help your account grow faster thanks to compounding.
You’re not avoiding taxes altogether. You’re just delaying when you pay them. You’ll still owe income taxes when you withdraw the money.2
Getting the most of your tax breaks
To maximize your immediate tax deduction, contribute as much as you can to your retirement plan. Remember, contributions reduce your taxable income dollar-for-dollar. Save more; pay less (in current taxes). For employer-sponsored plans that also match contributions, saving more not only helps you cut your tax bill, it also provides an immediate return on your savings by adding more money to your account. Can’t afford to save more right now? Boost your contributions gradually. Aim for one percent more each year. Even small savings increases may pay off over many years.
The key to making tax deferral really work for you is saving over many years. Start saving early in your career and continue to save and invest for as long as possible. This gives tax-deferred compounding a chance to really work. Potential account growth over 30 years can be substantially more than over 20 years. When it comes to investing, time is money.
Be tax smart
No one likes paying taxes but we all have to pay them. Many retirement accounts let you be smart about when you pay your taxes. You may end up with more money and have more options once you retire.
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1 The IRS sets annual dollar limits for qualified retirement plan contributions. For 2012, the limit is $17,000 in employersponsored plans and $5,500 in traditional IRAs.
2 Withdrawals from tax-deferred retirement plans are taxed at your ordinary income tax rate with withdrawn.