Tax Deferred Accounts 101

“‘In this world nothing can be said to be certain, except death and taxes.”

The Works of Benjamin Franklin, 1817:

It seems like an easy enough task… Put your money into investments and let it grow until you are ready to retire.   So why is there so much confusion?  Well, there are some concepts that must be understood in order to do it properly.  Many people find the whole idea of investing to be “out of their league” and so they never get started.  You will NOT be one of those people, because you are willing to start with the basics and really understand what needs to be done!

First, we must specify that there are places where you put money (Accounts) and then there are WAYS that that money is considered for taxes by the government (Tax Status). The tax status of the money you save is important (to you and to the government!)

You can, for example, choose to put money into a brokerage account that allows you to invest in the stock market.  When that money grows with the market, the newly “earned” money is called GAINS, and those gains can be taxed as income if you take them out of the account, unless they are in an account that is set up to be DEFERRED from paying taxes because you plan to use it at retirement age.

That isn’t too confusing! Honestly, they probably make it confusing so people are afraid to use tax sheltered accounts… But you know they are worth it, and you are ready!Great! OK, just one more little thing to add… There are two types of Tax Deferment….

Pre-Tax – Pre-tax means that you do not pay taxes on the money NOW, but you pay them when you withdraw amounts in retirement, you will pay taxes THEN.

Post-Tax – Post-tax means that you pay taxes on the money you invest NOW, but you will not pay taxes when you withdraw amounts in retirement, even on the amounts that it grows in interest/earnings until then.

Photo by rawpixel on Unsplash

A little bit of math done at this time will probably have you asking more questions, so let’s see what we find out… Let’s say you pay the government 15% in taxes on your income. If you earn, $7,000 at work, the government will take $1,050 of that money, leaving you with $5,950 to do with what you will. You can choose to invest that $5,950 and you will earn money from those investments.  When older-you takes out those investments and uses the money you earned, you will have to pay your tax rate at that time(maybe 15% or maybe more, depending on your income level) of what you earn to the government.  That is an example of a Taxable Account.

OR… You can use a tax-deferred account.  *

If you use a Post-Tax deferred account, you will invest your$5,950 and you want to invest it and you will earn money from those investments.  When you take out those investments and use the money you earned, you will NOT HAVE TO PAY any taxes on those gains.

If you use a Pre-Tax deferred account, you will invest your whole $7,000 (the government doesn’t take any yet) and you will earn money from those investments.  When you take out any of the funds, whether they were part of the initial investment or part of the gains, you will pay taxes on the money at your current income tax rate (maybe15% or maybe more).

So, the two tax deferred options are significantly better than the first option where you pay more taxes! Your tax rate will determine how much you are taxed when you take the funds out in retirement, and that is sort of a guessing game, but you know how much you are taxed right now, so you can run some numbers and judge what is better for you. BOTH OPTIONS ARE USEFUL! Depending on your situation, one may be better than the other, but you should do you best to take advantage of both as much as you can! Grow your nest egg as much as you can, and Old You will thank you later!

Photo by Soner Eker on Unsplash

If you work, your company may offer a company sponsored 401k,SIMPLE IRA, or some type of similar plan, which is a Pre-Tax option.  Try to contribute as much as you can to that!  Many companies also offer a“company match” earning you free money just for saving for your own future.There are different maximum amounts for the different types of accounts, and each year the amount may increase, depending on the government’s calculations.

Some other tax deferred accounts are Traditional IRA and ROTH IRA accounts.

                Traditional is Pre-Tax while the ROTH is Post-Tax. 

You can contribute as follows:

                $6,000 per year in 2019, plus

                $1,000 per year in 2019 if you are over 50.

NOTE: You can only contribute to EITHER a Roth or a Traditional, or a combination of both, up to the $6,000limit (or $7000 if over 50)… so, for example, you can put in $3,000 to a Traditional and $3,000 to a Roth…  but you cannot put in $6,000 to a Roth and $6,000 to a traditional in the same year.

IF you take advantage of all of these maximum limits in all of these accounts, you could have a tax “shelter” of over $19,000-$32,000per year!!  And any dollar saved from taxes is truly a dollar earned!

OH! And just one more thing…. There is also a MAX limit to contribute to an HSA (Health Savings Account) that may be available to you, depending on your health insurance setup.  If you do have an HSA available to you, that can even be BETTER than the other tax deferred accounts, since you NEVER pay taxes on the money you used out of an HSA to pay your medical costs!

*Keep in mind, some people will not qualify for tax deferred accounts because of their income levels and other factors, so you should ask a tax advisor if you think you might be one of those people.

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