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By Dan Schulte, Senior Vice President and Manager, Annuities and Insurance

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Like most things, taxation ebbs and flows. Today’s environment is no different – and it appears that, for now, taxation is on the rise. When the tax burden on individuals is increasing, the importance of tax deferral becomes especially important.

In this environment it’s important to consider tax-deferred strategies in your financial plan. This means that instead of paying tax on the returns of the investment now, the tax is paid at a later date leaving the investment to grow unhindered. Here are some strategies that may offer a tax deferral benefit for you:

Employer-Sponsored Retirement Plans – If you are eligible to participate in your employer’s retirement plan, i.e. 401(k), 403(b) or 457 plans, the investments grow tax free or tax deferred. Withdrawals are generally required to begin at age 72, unless you are still working at that time. Otherwise, distributions are generally available when you retire or change employers (also referred to as “separate from service”).  When you are ready to take withdrawals, they are subject to ordinary income tax.

If you change jobs, you can transfer to a new employer’s retirement plan or “rollover” the funds into a new IRA. This allows taxation to be delayed and tax deferral continues until distributions are required. Penalties may also apply on taxable distributions that are not rolled over if you are younger than age 55 when you separate from service.

Traditional IRAs – Investments in a traditional IRA grow tax deferred and, in some circumstances, your contributions may be tax-deductible. Withdrawals are required to begin at age 72 but may begin at age 59½ without penalty.  Distributions are subject to ordinary income tax and any withdrawals made prior to the age of 59½ are also generally subject to a 10% penalty.

Roth IRAs – Investment earnings in a Roth IRA also grow tax-deferred. Unlike traditional IRAs, contributions to a Roth IRA are not tax-deductible and withdrawals are not required during your lifetime. However, withdrawals that are made after five years and age 59½ are generally income tax free. Roth IRAs also give the added flexibility to withdraw your contributions at any time without tax or penalty if the funds are needed prior to retirement. However, any withdrawal or investment earnings that are taken prior to age 59½ are subject to ordinary income tax and generally a 10% penalty.

Tax-Deferred Annuities – In addition to IRAs and employer-sponsored retirement plans, fixed and variable annuities, issued by insurance companies, offer tax-deferred accumulation. Tax-deferred annuities do not limit contributions and do not require distributions at age 72 as is the case with other tax-deferred accounts such as IRAs and employer-sponsored retirement plans.

A fixed interest annuity will pay a guaranteed rate of interest for specified number of years.   A variable annuity allows you choose how the money will be invested from a pre-selected list of funds (these funds are called sub-accounts.  Some variable annuities offer optional income “living benefit” features and enhanced death benefit features that are available at an additional cost.  The tax deferred aspect of variable annuities allows for tactical management of the investment subaccounts available while avoiding the tax bill associated with frequent trading outside of a tax deferred account.

Keep in mind annuities are long-term, tax-deferred investments to help save for retirement. They involve risk and may lose value. Earnings are taxable as ordinary income when distributed and may be subject to a 10% federal tax penalty if withdrawn before age 59½. All contractual guarantees are based on the claims paying ability of the issuing company.   

Example: The Power of a Tax-Deferred Strategy

The following example is based on hypothetical situation assuming an initial contribution of $100,000 with a 7% annual rate of return over a 25-year period. In this example, a 40-year old investor in the 28% tax bracket increases the value of the investment to $542,743 in a tax-deferred account. However, if the investment remained in a taxable account over the same 25-year period, the investment would grow only to $341,875. The tax-deferred aspect of the investment allows the investor to accumulate approximately 37% more of the asset to use in retirement. Keep in mind that if the investor withdraws all of the tax-deferred investment at age 65 and is in a 28% tax bracket, after paying taxes the final amount would be $418,775.

Prepare Now for Tax-Deferred Strategies

There are significant advantages to tax-deferred investments, and they should be strongly considered when planning and building an investment portfolio for the long term. Understanding the features, benefits and risks with each investment vehicle is essential to success. With the escalation of tax rates, taking full advantage of tax deferral is a benefit every investor should consider. Your financial advisor and your tax professional can help determine if any of these tax-deferred strategies is appropriate in your situation.

Benjamin F. Edwards does not provide tax advice; therefore, it is also important to consult with your tax professional for additional guidance tailored to your specific situation.

April 27, 2021 |