How can tax deferral boost your retirement income?

More than half of all working-age Americans have IRA or 401(k) accounts.¹ There are good reasons for the huge popularity of these accounts and others, such as annuities. Chief among those reasons is that they’re typically tax deferred.^* That tax status can be a bonus to many retirement accounts since your savings can grow for years without the need to pay taxes on it. Let’s take a look at how you might benefit from tax deferral.

First, some definitions. “Tax deferral” doesn’t mean “tax-free.” You’re almost always going to pay taxes at some point on the money you put into a tax-deferred account and on the interest, profits, dividends, or capital gains that money generates over the years. The only question is when you’ll pay. With tax-deferred accounts, you pay taxes when you withdraw the funds during retirement.² The partial exception is a so-called “nonqualified” account, in which you invest with after-tax money and, upon making withdrawals,³ you pay taxes on your interest or other earnings.⁴

That’s a big deal because any income you put into a qualified plan directly lowers your taxable income by that same amount, which lowers your tax bill. That’s a benefit you get now, without waiting for your retirement. Sure, you generally can’t spend the money you just put into a tax-deferred account until retirement; but it’s not gone, just temporarily out of reach – and earning more money for you.
 

In addition, tax deferral enables you to make more money over the years until your retirement through the power of compound interest. Beyond any immediate tax-bill savings, the money you put into a tax-deferred account makes money (such as interest), which then makes more money, over and over.

Here's an example. Say you contribute $22,500 a year to a 401(k). Assuming a growth of 6% annually, after 30 years, your account is worth $2,181,097. If you’d made the same contributions to a non-tax-deferred account with a tax rate of 20%, after 30 years, your account would be worth $1,701, 890. In this example, the tax-deferred account earns you an additional $479,207.⁵

Another way to save money with tax-deferred income is based on the tax bracket you’re in now and the bracket you may be in when you retire. Many people put money (before taxes) into their retirement accounts when their income bracket is relatively high and take the money out – and pay taxes on it – during retirement, when they are typically in a lower tax bracket. The lower bracket means they pay less in taxes.

On the other hand, anyone considering a tax-deferral strategy should also be aware of other factors. For example, tax-deferred accounts such as IRAs generally come with penalties of 10% if you take money out before you’re 59 ½ .⁶ If you think of your retirement savings as a rainy-day fund that you could use at any time, this could be a concern for you.

Here’s something else to keep in mind: Although you’re likely to be in a lower tax bracket when you retire and make withdrawals, what if you’re not? Those who want to maintain their full standard of living in retirement may need to take large distributions that are equal to their previous annual earnings. That could keep them in comparable tax brackets, costing them some of the benefits of tax deferral. Worse, the familiar deductions they used to have to offset their high bracket (e.g., mortgage, child credit, or single-filer rate for widows/widowers/divorcees) may no longer be available to them.

What’s the best course for you? Diversification of pre-tax and after-tax accounts is a plus because you can draw on the distinct advantages of each when you need it. For example, you can draw more heavily from pre-tax accounts when your bracket is low and draw on after-tax accounts when your bracket is high to moderate your overall tax bill. Also, you’ll want to identify your risk appetite toward retirement and what investments align with it.

As always, we suggest you work with a trusted financial professional.