Finance 101: Tax Deferred Growth
What Does Tax Deferred Mean?
Simply put, it means that you do not pay taxes on current returns on investment. Taxes are paid at a later date.
When you filled out your tax return this year, you probably noticed that there was a line for you to report any interest paid to you by banks, brokers, etc. You may have received a 1099-INT. Normally, these amounts reported are taxed at the individual tax rate of anywhere from 15 to 35 percent when you pay your taxes.
How Do Taxes Affect My Rate of Return?
The short answer is that any interest you earn is reduced each year by the amount that is taxed from those earnings.
Using your current tax rate, this means that the interest you received was actually reduced at tax time by anywhere from 15 to 35 percent. An average family, then, is actually keeping about 25 percent less of the interest they receive from savings, CD’s, etc.
During your working life, if you save and put money away for the future, you have time on your side. Interest compounds and leads to increased growth of your savings. Using the Rule of 72, this means that a rate of return of 4 percent doubles your money every 18 years. If you pay 25 percent of this money in taxes, using the same Rule of 72, (3 percent rate of return) it actually takes 24 years to double your money. In other words, taxes can make you wait much longer to reach your goal.
How Can I Avoid Taxes Legally?
You can legally avoid taxes by placing a portion of your savings for the future in tax deferred vehicles, such as annuities.
Our income is greatest during our working lives. For most of us, this means that we pay the highest rate of taxes during the years we are working to accumulate wealth for retirement. Once we retire, our incomes normally go down, and we pay reduced taxes during this period of our lives. By deferring taxes until after retirement, we can accumulate wealth at a faster rate and in most cases pay less in taxes when we use the money in retirement. Withdrawals from tax deferred savings are normally taxed at the individual rate at the time of withdrawal. In the case of a Roth IRA, there are no taxes paid at the time of withdrawal, subject to certain conditions.
How Much More Could I Grow My Savings?
The following table shows how a tax deferred investment can benefit your real rate of return.
TAX BRACKET 15% 25% 28% 33% 35%
Annual Tax Deferred
Interest Rate TAXABLE EQUIVALENT YIELD
3.00% 3.53% 4.00% 4.17% 4.48% 4.61%
3.50% 4.12% 4.67% 4.86% 5.23% 5.38%
4.00% 4.70% 5.33% 5.56% 5.97% 6.15%
4.50% 5.29% 5.99% 6.25% 6.72% 6.92%
5.00% 5.88% 6.67% 6.94% 7.47% 7.69%
5.50% 6.47% 7.33% 7.64% 8.21% 8.46%
6.00% 7.06% 7.99% 8.33% 8.96% 9.23%
6.50% 7.65% 8.67% 9.03% 9.71% 10.00%
7.00% 8.24% 9.33% 9.72% 10.45% 10.77%
7.50% 8.82% 9.99% 10.42% 11.20% 11.54%
Taxable Equivalent = (Tax Deferred Interest Rate) X [1 ÷ (1 - Your Tax Bracket)]
Are Annuities Right For Me?
While annuities providing tax deferred growth are a good choice for many, they are not suitable for every situation. The best course is to have a one-on-one, no obligation consultation where your plans and needs are analyzed individually.
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