When discussing when you should buy an annuity, we mentioned the tax deferred status of certain accounts. For example, many retirement devices, such as a 401k account or an annuity, allow the taxpayer to defer paying taxes until retirement. Let’s explore why tax deferral is such a powerful tool.
Pay Less in Taxes
With tax deferral, how much you owe in taxes is calculated based on your income when you pay the taxes. Usually this means you’ll end up paying less taxes if you defer taxes until retirement. But why? While you’re working you’re likely to be earning more income than you will once you’re retired. Therefore, when you end up withdrawing your money from a retirement account with a tax deferred status, you’ll be paying taxes at a lower tax rate that if you had paid while still employed.
For example, let’s say while you’re employed you’re making between $91,150 and $190,150. That puts you in the 28% tax bracket. Most people won’t be making over $91,150 in income during retirement. Let’s say you make between $9,275 and $37,650 in income while you’re retired. The decrease in annual income drops you to the 15% tax bracket. So by deferring payment of your taxes until retirement, the money you withdraw from your 401k or annuity will be taxed at a tax bracket 13% less than had you paid while working.
Build Wealth
Paying less taxes in the future isn’t the only benefit of tax deferral. Since you aren’t currently paying taxes on the money you’ve put in a tax deferred account, that money can be put to use to help you gain wealth. Basically, the money in a tax deferred account, like a MYGA, can take full advantage of compound interest and capital gains.
In a traditional account, you’ll be taxed on the gains you make every year. So, for example, if you have $10,000 in a typical account and after one year the value of the account has increased to $11,000, that’s a great return, but you’ll be taxed on the $1,000 gain. So you won’t actually have $11,000 after the first year. You’ll have $11,000 minus taxes. So, for example, you might end up with $10,700 after taxes. In a tax deferred account you wouldn’t pay any taxes yet, so you’d keep all of the $1,000 gain and have $11,000.
That extra $300 is nice, but the real benefits of tax deferral are seen over time. In year 2, if you make the same 10% return on investment in the traditional account, you made $1,070. Putting you at $11,770. But that $1,070 gain needs to be taxed, so it’s actually $749 after taxes. So after year 2 in the traditional account, you’ve got $11,449. In the tax deferred account, you’d have $12,100.
If we pushed this scenario out to 10 years, the traditional account would have a balance of $19,671.52, while the tax deferred around would have a balance of $25,937.43. That’s almost a $6,000 difference on an initial investment of only $10,000.
As explained above, when you begin withdrawing, you’ll have to pay taxes, but likely at a smaller tax bracket.
You can experiment yourself with the tax deferred calculator.
Summary
To summarize, there are two huge benefits of tax deferral. The first is that you’re likely going to end up paying less in taxes. During your working years you are likely in a higher tax bracket than you’ll be once you retire. The second benefit is that you get to hold onto that tax money and put it to work for you during the tax deferral period.
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