What Are Tax-Deferred Accounts?

Daniel Penzing
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How to Defer Taxes

Taxes are a fact of life, but you don’t have to face them head-on when you choose to defer taxes on retirement accounts. In order to defer taxes and grow your money in a more tax-friendly way, one or more of these retirement accounts might be suitable for your situation.

The two main types of accounts that qualify for tax-deferred status are Traditional IRAs and 401(k) accounts.

A Traditional IRA is an account owned by an individual where you put money into your account pre-tax. Then, you pay taxes on the withdrawals after you retire.

A 401k account is an employer-sponsored retirement plan, on which you’re able to contribute pre-tax money into your account.

In both of these instances, the money grows tax-free until it is withdrawn or the account is closed.

Borrowing from your retirement account before retirement can have a serious negative effect on your financial life. The money that’s removed from the account is treated as ordinary income taxed in addition to a 10% penalty that’s levied for any money you took out before the age of 59½.

What Are the Best Tax-deferred Investments?

Tax-deferred accounts are a growing popular investment plan to pick up some retirement income for yourself and your family. If accepted, your contribution will earn tax advantages until you remove the funds. The value of the investment will increase based on the income or gains earned.

The plan is similar to pension plans; however, it’s up to you to choose what type of investment you would prefer and who will administer the plan. To be eligible for the tax-deferred account, you must be over the age of 50 and voluntarily contribute on a regular basis over a long period of time. To get more information about your personal eligibility and which types of plans are best for you, contact your employer.

Since your contributions will earn tax advantages before making a withdrawal, the investment will increase by at least the amount earned through the years. The tax-deferred accounts will appreciate in value, and you will have more accessibility than you would otherwise if you kept the funds in a regular savings account.

Traditional IRA

First and foremost, it’s important to know that an IRA is an account and not a product, as are 401k’s, 403b’s, and the like. In fact, an IRA may be purchased with specific products such as CDs, mutual funds, stocks, etc. The account is designed to be a tax-deferred investment, meaning that gains are not taxable until the time of withdrawal.

There are two types of IRA’s: a traditional IRA and a Roth IRA. The two are similar but there are some distinct differences. First, unlike a traditional IRA, contributions to a Roth IRA are not tax-deductible. Second, the earnings or gains in a Roth IRA grow tax-free and are not subject to taxes when they are withdrawn. In a traditional IRA, contributions are tax-deductible and withdrawals are subject to income tax.

Not everyone can contribute to a Traditional IRA or Roth IRA. The person must have sufficient earned income and must not be a dependent on anyone else’s income tax return.

Generally, once you reach age 70.5, you must begin to withdraw from your IRA and you will incur penalties if you don’t.

Health Savings Account

A Health Savings Account (HSA) is an account that is used to cover expenses that qualify as preventive care. An HSA is an extension of a High Deductible Health Plan (HDHP). The money that is deposited in an HSA belongs to the person who opens it.

The money in an HSA can be used for any purpose, including paying for non-prescription medications, and can be withdrawn to pay for uncovered medical expenses without penalty. HSAs can be opened by anyone, but some insurance companies or employers will make them available as a benefit. Some institutions and plans require a minimum balance in the account if they are to be opened for a specific purpose, such as the employee’s retirement.

Other than by pre-tax payroll deduction, funds can be contributed to an HSA through employer contributions, not-taxed Roth IRA contributions, and by rolling over a flexible spending account, Health Reimbursement Account, or Health Savings Account. HSA balances roll over from year to year, if the account is not closed, and last for as long as the owner lives.

Under the new Patient Protection and Affordable Care Act, if you have an HSA, you will have to purchase a High Deductible Health Plan from one of the state exchanges that are available. This will help to pay for the non-covered expenses that may come up when you have a health emergency.

Early Withdrawals Are Expensive

Tax-deferred retirement accounts are designed to make it advantageous to save for a rainy day. There is a lot of money at stake for financial institutions, and with this much money at stake, it’s no surprise that financial institutions and governments are involved.

As a result, the ground rules for tax-deferred accounts can be quite complex. The purpose of this article is not to provide a comprehensive description of all the rules but rather to give you a working understanding of how the tax rules work.

In addition, the tax rules change all the time, which means that you need to be careful to follow the rules for whichever tax year applies to you.

Take Advantage of Tax-deferred Accounts to Save Big on Taxes

One of the greatest taxation myths ever told is that tax-deferred savings plans are bad and retirement accounts are good. Not only is this false, it is a flat out lie.

Tax-Deferred Savings Plans > Retirement Accounts

Tax-deferred accounts are the foundation for your self-directed retirement plan. They give you a way to build and grow your retirement nest egg using your after tax dollars, which is something you cannot do with a retirement account.

Not only is using a tax-deferred account for retirement planning tax efficient for people in certain income tax brackets or high tax states, but it is also tax-efficient for those who live in retirement tax states.

Tax Deferred Accounts > Tax Free Accounts

Many Americans choose Roth IRAs over traditional IRAs because they are not taxed upon withdrawal. Although this sounds nice, since you do not pay taxes, you give up the ability to use tax-deferred accounts as your foundation for retirement planning. This is a huge loss and shouldn’t be ignored.

Tax deferred retirement savings accounts are superior to tax free retirement savings in every way except one “ the tax free distribution. This is how they are able to reflect the same after tax value.