The term tax-deferred simply means that you’ll pay taxes at a later date. Investment accounts that are considered tax deferred typically include IRAs. plans covering self-employed persons, and 401ks. In addition, many insurance-related vehicles, such as deferred annuities and certain life insurance contracts, may also provide tax-deferred benefits.
The power of compounding
When it comes to retirement planning. retirement accounts that are tax-deferred can have a big impact on your retirement savings, by allowing your money to grow quicker than if it were in a taxable investment account. How? With a process called compounding.
According to Investopedia, the definition of compounding is the ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings.
The process of compounding simply allows your entire contribution (principal) and any additional earnings that you may have accumulated to earn interest. Essentially,
you’re earning interest on your interest. Over an extended period of time, the compounding effect can make a big different in the accumulation of your retirement nest egg – for the better!
Moreover, contributions in your tax-deferred accounts are often made when you’re earning a higher income and typically subject to a higher tax rate. So when it comes time to retire and begin drawing income (distributions) from your tax-deferred accounts, you may find yourself in a lower tax bracket and paying less income tax on your withdrawal than you would have when you originally invested your money.
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Disclaimer: The information in this article is not intended to be tax or legal advice and should not be relied on for the purpose of avoiding any federal tax penalties. Please consult with a qualified tax professional or consult with a professional financial advisor.