What is tax-deferral?
Tax-deferral is a popular feature that positively affects most individual retirement accounts (IRAs) and many insurance products, such as annuities. Utilizing this approach, individuals are able to postpone their tax payments until a later time. Taxation will typically occur once funds are withdrawn from the contract, allowing the owner to plan for when they’d like to pay taxes (normally when they’re in a lower tax bracket).
What products are tax-deferred?
401k’s, 403b’s, deferred annuities, IRAs and Roth IRAs are all commonly recognized as tax-deferred products. A deferred annuity will normally credit an interest rate that provides an attractive yield for those looking to grow their funds outside of a 401k/403b. In contrast, 401k’s and 403b’s tend to offer higher rates of return and are funded by resources that come directly from the owner’s pay check and/or by contributions made by the employer. Roth IRAs offer the unique ability to open a contract with post-taxed funds, while eliminating the taxation on any future earnings. Roth IRA’s cannot be opened using short-term products as they must be in force for at least five years to qualify.
Do tax-deferred products have a downside?
While useful, tax-deferral still carries one major flaw with it-- the transfer of wealth. Deferred products are great for those looking to bolster and utilize their retirement funds. However, these products can become disadvantageous for any beneficiaries. When an individual passes away, any remaining funds will be passed on to their beneficiaries (or estate), potentially causing a taxable event. If the account is an IRA, the beneficiary will be taxed on the entirety of the contract; differing from a non-qualified contract which only taxes the earnings. There are certain ways of avoiding this drawback (ELCO’s strategy here), but generally the beneficiary will be liable for any taxation.
How does compound interest work?
Compound interest allows accumulated interest to earn additional interest. There are a variety of products that can be used to conservatively build value. However, many require the owner to pay taxes on the earnings at the end of each year (like CDs). This can limit the growth of the funds, opposed to an account that has a tax-deferred status which allows a contract to continuously build on the existing earnings. The difference of a few dollars may not seem like a lot at first, but it will ultimately result in a major benefit for the owner. The following graphic exhibits the long-term difference between an account that is deferred and one that isn’t. If two individuals purchased two different products, worth $100,000 each and earning roughly 3% APY, the growth after 10 years would show a $10,000 plus difference. After 20 years, the gap between the two widens to almost $30,000, clearly demonstrating the true power of tax-deferral.
Products with compound interest offer a financial and strategical advantage for those looking to prepare for retirement. The ability to develop a nest egg by utilizing compound interest offers an excellent avenue for building wealth. The downside of using a tax-deferred product is the potential effect on the beneficiary after the current owner passes away. However, despite the fact that this can create a potential tax burden for the recipient, the pros outshine the cons. Building a secure nest egg for retirement is essential. By using the power of tax-deferral, it has never been easier.
This article is for informational purposes only. The details and descriptions listed above are only partial, for more information please contact your local financial or tax advisor.