No matter your age, income or financial goals, taxes can take a bite out of your long-term savings. That’s why it makes sense to make the most of as many opportunities as you can to set aside money in tax-deferred IRAs and workplace retirement savings plans such as 401(k)s and 403(b)s. Tax benefits and compound growth make small, regular, contributions grow into more than you might think. Over long periods of time, tax deferral makes an incredible difference in the amount of money you have in a retirement plan. To understand the basics, let’s look at a simple example.
Tax-deferral is the single most important benefit of these plans. Here’s what it means: You can postpone taxes on any earnings you make on the money in your tax-deferred accounts. And in many cases, you can also postpone federal and state income tax on the money you contribute to your account.
The chart below shows a hypothetical $10,000 investment1, returning a steady 6% in three tax situations: tax-deferred2, a 20% rate and a 40% rate. As you can see, the tax-deferred account grows faster than the accounts that pay taxes each year.
When Taxes Are Due
Eventually you’ll have to pay the taxes you’ve deferred on your retirement savings. But here’s the good news. You may be in a lower tax bracket in retirement, so the taxes you pay will be less than if you had paid them during your working years. And you only pay tax on the amount you withdraw from your tax-deferred accounts. The rest of the money in your tax-deferred account continues to grow tax-deferred—and compounding continues to work its magic over time.
1 This example is hypothetical and does not represent any particular investment.
2 Taxes would be due upon withdrawal for the tax deferred investment
3 Assuming 15% Federal and 5% state tax rates
4 Assuming 35% Federal and 5% state tax rates