Tax Deferral Strategies
Deferring taxes as long as possible is a common investment goal. The income you earn on your principal is allowed to compound tax-deferred until you withdraw the money. Only at the time of withdrawal do you become liable for taxes.
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Tax deferral is encouraged by the government to stimulate long-term planning, especially retirement planning. Individual retirement accounts, Keogh plans, 401(k)s, and other qualified retirement plans all benefit from tax deferral. In addition, many insurance-related vehicles, such as annuities, (both fixed and variable) and certain life insurance contracts, provide the benefit of tax deferral.
Benefits of deferring taxes
The benefits of deferring taxes as long as possible are substantial. The compounding effect can be dramatic over an extended period of time and can make a significant difference in the accumulation of your retirement nest egg. In addition, the difference can be even more dramatic when investing in IRA, (or any other type of funds) in tax-deferred vehicles at the beginning or the end of the year. Using a hypothetical 8 percent return, (compounded annually) if the maximum annual contribution (under 2001 tax law) were invested in an IRA at the start of each year, after 30 years it would have accumulated $533,482. On the other hand, if the contribution were made at the end of each year, the IRA would have accumulated $493,965, a difference of $39,517. (Assumes $5,000 annual contributions for 2008 and thereafter.)
Tax reduction investment options
Another nice feature of the tax-deferred investment is the flexibility to choose from the complete spectrum of investment vehicles. Under the tax-deferred umbrella, you can select an equity portfolio, a fixed income portfolio or a combination.
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A note of caution: When formulating your tax plan, recognize that most tax-deferred investments do incur penalties for withdrawal prior to age 59½. The government not only taxes you at that point, but also imposes a 10 percent penalty. Once again, the government is encouraging long-term planning.
For the reasons discussed above, tax-deferred income investments which reduce your current tax liability and can increase your net worth may be an attractive addition to your portfolio.