Tax Tip Tuesday: The Power of Tax Deferral

Mar 5, 2024

By Dan Schulte, Senior Vice President and Manager, Annuities and Insurance
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The majority of income in the United States is taxable. Whether employment income, capital gains or dividend income from your stock and bond portfolio, or even rent from an investment property, you will likely have to pay tax on the income. However, not all income is taxed the same way.

If you invest in retirement accounts and certain other tax-advantaged accounts, you can benefit from tax-deferred growth.

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-deferred. Withdrawals are generally required to begin at age 73, unless you are still working at that time. Otherwise, distributions are generally available when you retire or change employers (also referred to as when you “separate from service”). When you are ready to take withdrawals, they are subject to ordinary income tax. If you change jobs, you can leave your retirement plan where it is, transfer to a new employer’s retirement plan or “roll over” the funds into an IRA. This allows taxation to be delayed, and tax deferral continues until distributions are required. Penalties may also apply on taxable distributions that you receive when you separate from service if you are younger than age 55 and they are not rolled over to another eligible retirement plan or IRA.

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 73 but may begin at age 59 1/2 without penalty. Distributions are subject to ordinary income tax, and any withdrawals made prior to the age of 59 1/2 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 59 1/2 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 of investment earnings that are taken prior to age 59 1/2 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 73 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 a specified number of years. A variable annuity allows you to 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.

Example: The Power of a Tax-Deferred Strategy
The following example is based on a hypothetical situation assuming an initial contribution of $100,000 with a 7% annual rate of return over a 20-year period. In this example, being in the 22% tax bracket increases the value of the investment to $386,968 in a tax-deferred account. If the investor withdraws all the tax-deferred investment and is in a 22% tax bracket, after paying taxes the final amount would be $323,835. If the original investment remained in a taxable account over the same 20-year period, the investment would grow only to $289,571.

Consider Implementing 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.

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 59 1/2. All contractual guarantees are based on the claims-paying ability of the issuing company. 


IMPORTANT DISCLOSURES: The information provided is based on internal and external sources that are considered reliable; however, the accuracy of this information is not guaranteed. This piece is intended to provide accurate information regarding the subject matter discussed. It is made available with the understanding that Benjamin F. Edwards is not engaged in rendering legal, accounting or tax preparation services. Specific questions on taxes or legal matters as they relate to your individual situation should be directed to your tax or legal professional.