Delaying, or deferring, when you pay income tax on the earnings of an investment provides a means to "earn interest on your interest."
Ways to defer income taxes
The simplest ways to take advantage of tax deferral are with qualified retirement plans, such as a 401(k) plan or an IRA. For purposes of discussing tax deferral, let’s ignore the potential additional benefits of any tax deduction you may get for contributing to these plans. Other ways to defer taxes include annuity contracts and even with stock investments.
How tax deferral works
IRA contributions are the simplest to demonstrate. Let’s compare the difference between making non-deductible $5,000 annual contributions to an IRA with saving the same amounts in a taxable savings account. We will assume that both accounts earn 6% annually. For the savings account, the values are after taxes of 28% with distributions from the IRA being taxed when distributed.
| Year | Total Contributions | IRA Value | Savings Account Value |
| 1 | $5,000 | $5,000 | $5,000 |
| 2 | $10,000 | $10,300 | $10,216 |
| 3 | $15,000 | $15,918 | $15,657 |
| 4 | $20,000 | $21,873 | $21,333 |
| 5 | $25,000 | $28,185 | $27,255 |
| 6 | $30,000 | $34,877 | $33,432 |
| 7 | $35,000 | $41,969 | $39,877 |
| 8 | $40,000 | $49,487 | $46,599 |
| 9 | $45,000 | $57,457 | $53,612 |
| 10 | $50,000 | $65,904 | $60,928 |
| 15 | $75,000 | $116,380 | $102,532 |
| 20 | $100,000 | $183,928 | $153,932 |
| 30 | $150,000 | $395,291 | $295,895 |
| Taxes Due* | -$68,681 | None | |
| Net After Tax | $326,610 | $295,895 |
* Assumes contributions to the IRA were not tax deductible and therefore taxes are only calculated on the earnings when distributions are taken.
Why tax deferral works
Continuing to earn returns on funds that would have otherwise been paid in taxes enables your funds to grow faster and to accumulate to a greater amount. You should also know that the higher the earnings rate, the more tax-deferral works to your benefit.
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The information provided should not be considered as tax or legal advice. Please consult with your tax advisor and/or attorney regarding your individual circumstances.
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