How to Choose the Right Tax-Deferred Savings Account For Your Retirement Needs
Part of the torment of living through the pandemic was feeling wholly unprepared for the challenges that life had unexpectedly thrust upon us, as well as the overwhelming sense of uncertainty regarding the future.
Specifically, financial anxiety abounded, with stomach-twisting questions such as “Will I have a job next week?” and “Are my savings enough to supplement my loss of income?” plaguing the minds of millions of Americans.
For many of us, the primary takeaway of the pandemic was clear - we would do everything in our power not to be caught unawares again. Sadly, the economic aftershocks of the pandemic are still being felt by many. According to a 2022 study by Bankrate, more than half of Americans are behind on their retirement savings, with close to 35% of respondents claiming that they are significantly behind on their envisioned retirement plan.
Fortunately, it is possible to get back on track with your retirement goals by undertaking a clear and structured process of retirement planning. This exercise entails considering your investment options, taxable income, and what your ideal scenario of financial freedom looks like. This scenario looks different for everyone, and that's part of the beauty of this exercise. Do you want to spend your golden years on the beach and go fishing all day, or would you like to spend months at a time ticking off dream destinations from your bucket list? YOU can decide which dream to make a reality.
One of the most accessible and effective approaches to achieving your financial and retirement goals is by using a tax-deferred retirement account, which postpones taxation until withdrawal, as opposed to upon making the contribution.
Join me in exploring the different types of tax-deferred retirement accounts, their various advantages, and how to choose the option that will help cement your financial freedom.
What Are Tax-Deferred Accounts?
A tax-deferred account allows the account holder to make contributions using pre-tax dollars, with taxation being postponed until you withdraw money.
In the context of retirement, these are usually individual retirement accounts (IRAs), which are a type of investment account that individuals can set up and fund themselves, or employer-sponsored retirement plans such as 401(k)s.
A tax-deferred retirement account falls into the category of immediate tax benefits since the tax liability on taxable income is delayed to a future date.
If your current workplace doesn’t offer an employer-sponsored plan, then creating and funding your own tax-deferred retirement account is imperative to help ensure that your retirement savings are sufficient for the life that you deserve.
What Is the Difference Between a Tax-Exempt and a Tax-Deferred Account?
Both tax-exempt and tax-deferred accounts are tax-advantaged accounts, meaning that they have the ability to mitigate income taxes. However, with a tax-exempt retirement account, your annual contributions are made with after-tax dollars. Generally, as a result, investment earnings or early withdrawals are tax-free. Importantly, even though these withdrawals may be tax deductible, penalties may be incurred in some cases.
A tax-deferred retirement account, on the other hand, involves paying taxes on investment returns, while contributions for retirement savings, and withdrawals in the cost basis may be income tax-free.
Examples of tax-advantaged retirement savings accounts that are tax-exempt include Roth IRAs and Roth 401(k).
While both of these types of accounts can assist you in reaching your financial goals, they need to be nourished. Think of these accounts as seedlings. Just as a seedling requires nourishment and care in order to grow into a STRONG AND HEALTHY TREE, a tax-deferred retirement account requires regular contributions and careful management in order to grow into a substantial nest egg that can provide financial security in retirement. Just as a tree provides shade and fruit for its owner, a tax-deferred retirement account can provide financial benefits in the form of tax savings and a steady stream of income during retirement.
Benefits of Tax-Deferred Savings Accounts
The tax advantages of tax-deferred retirement accounts mean that your contributions are larger since you do not have to pay taxes before making them. As such, the effects of compound interest have the potential to be amplified, leading to the potential of increased investment gains.
Additionally, tax-deferred accounts work by offering account holders immediate relief on income taxes, such as capital gains tax.
Tax-deferred accounts also allow their users to leverage the effects of inflationthrough tax deferral - a unit of a given currency, today, is worth more than a unit of the same currency
tomorrow. Hence, if you pay taxes today, it is usually more expensive than if you pay taxes tomorrow.
Types of Tax-Deferred Accounts
There are various types of tax-deferred accounts available to those dedicated to achieving financial freedom. Each comes with its own pros and cons, and the appropriate option for you will depend on your unique circumstances.
When considering a tax-deferred account, it is important to carefully weigh the benefits and drawbacks of each option. Some key factors to consider may include the level of risk involved, the potential for returns, and the tax benefits offered by the account.
Traditional IRAs
Traditional IRAs allow users to maketax-deferred investments with pre-tax money. Individuals only incur taxes upon retirement, at which point they pay tax on the withdrawal value in their traditional IRA account according to their current tax bracket. Due to the benefits offered by this tax-deferred investment and the fact that you pay income tax on your investment according to your tax bracket, traditional IRA contributions are a prudent choice.
This type of tax-deferred account may be ideal for individuals whose places of work do not offer a workplace retirement plan.
401(k) Tax-Deferred Retirement Accounts.
401(k)s are a type of employer-sponsored retirement plan which offers usersa plethora of benefits. For example, employers can match their employee’s 401(k) contributions, thereby growing their retirement accounts at a rate that would otherwise not be possible considering an employee’s salary. Moreover, annual contributions made to your investment account can be deducted from your taxes in the same tax year in which the contributions were made.
This type of tax-deferred account is especially lucrative for individuals with a high income that will be in a lower tax bracket at the time of their retirement since they will pay less income tax on their nest egg.
Tax-Deferred Annuities
A tax-deferred annuity involves an individual making periodic payments to an insurerwho agrees to pay them, either in a lump sum or installments, in the future. The fact that the annuity is tax-deferred means that the individual will only incur taxes on their received payments.
There are different types of tax-deferred annuities, with fixed annuities offering a guaranteed1 rate, while variable annuities require payments of different amounts according to the performance of sub-accounts, similar to the mechanism of mutual funds. This type of annuity can be a good option for those who are comfortable with a bit more risk and are looking for the potential for higher returns.
Overall, tax-deferred annuities can be a useful tool for those looking to save for the long term. By choosing the right type of annuity for their individual needs and risk tolerance, individuals can take advantage of the tax-deferred nature of these investments and plan for a confident financial future.
Tax-Deferred Savings Bonds
U.S. savings bonds are a type of tax-deferred investment that matures over time and are a financial vehicle that assists governmental spending issued by the U.S. Department of Treasury. Some bonds pay interest periodically, but U.S. savings bonds do not payout until they have matured or are redeemed, accruing interest until that point.
This is a lucrative investment for those who are risk-averse and who wish to make use of the favorable rules around the taxes associated with these bonds.
Overall, U.S. savings bonds can be a wise option for those seeking a low-risk investment that offers favorable tax treatment. They can be a reliable way to grow your savings over the long term and can be an important part of a diversified investment portfolio.
How to Leverage Tax-Deferred Savings Accounts for Retirement
Choosing the approrpiate tax-deferred retirement option is A CRUCIAL DECISION in your journey toward financial freedom. Making a prudent choice ensures that your funds remain adequately shielded from taxes so that you can retire with the nest egg that you deserve. In some cases, other tax-deferred vehicles, such as bonds and annuities, may be favored over tax-deferred accounts for various reasons.
A surefire way to achieve timely and assured financial freedom is to use a financial planner to help guide you in funding and structuring your retirement accounts.
As a Wealth Management Advisor, I specialize in providing my clients with clear, actionable, and effective plans to help them attain their financial goals and freedom. By making the correct choices now, you can change the future for yourself and your loved ones, ensuring that you can spend your golden years with those you cherish.
It’s time to put your financial tools to work. The Legacy System is the generational wealth system to help you establish the legacy you have always wanted to leave.
This material is intended for general public use. By providing this content, Park Avenue Securities LLC and your financial representative are not undertaking to provide investment advice or make a recommendation for a specific individual or situation, or to otherwise act in a fiduciary capacity. Guardian, its subsidiaries, agents, and employees do not provide tax, legal, or accounting advice. Consult your tax, legal, or accounting professional regarding your individual situation. 1All guarantees including the death benefit payments are dependent upon the claims paying ability of the issuing company.
References
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- https://www.investopedia.com/terms/t/tax-deferred-savings-plan.asp7. https://www.investopedia.com/terms/t/traditionalira.asp
- https://www.investopedia.com/articles/investing/102216/understanding-401ks-and-all-their-benefits.asp
- https://www.investopedia.com/terms/d/deferredannuity.asp
- https://www.investopedia.com/terms/v/variableannuity.asp
- https://www.investopedia.com/terms/u/ussavingsbonds.asp