What does it mean to save in a ‘tax-deferred’ account?

There are several different ways to save money on taxes over time — and all are crucial when it comes to building your nest egg. There are taxable investment accounts, pre-taxed, tax-deferred, post-tax, and plenty more terms out there. It can get complicated, but that’s why we’re here.

To make money. And to make making money simple. That’s simple!

What is a tax-deferred account?

If your money is placed into some sort of investment before you are paid, then that money is being invested pre-tax. You will not be paying any taxes on that money today. That money will grow — also tax-free!

However, that doesn’t mean you won’t pay taxes on it!

Quite the contrary: You will pay taxes on the money when you take it out of the account, preferably (read: pretty please!!) when you hit retirement age.

In the meantime, however, you will not have been paying taxes on any dividends, or any investment gains.

In other words, you are deferring the taxes you will pay on a certain amount of your present-day pre-tax income for the future. At that future date, you will have to pay taxes on what you remove from the account.

The most well-known form of a tax-deferred account is the 401(k) offered by many companies nationwide. There are also 403(b)’s offered to public school employees and other nonprofits such as religious groups.

Here are some further readings on the subject if you’re interested (and you’ve come this far so I assume you’re at least mildly intrigued, eh??)

What is the difference between a “Traditional” and a “Roth” retirement account?

What is the difference between a 401k and an IRA?

When do you want to pay your taxes?

There are plenty of loopholes, involved, but to keep things simple, here’s the basic question behind your investment decisions: When do you want to pay your taxes?

You have two options:

  1. This year: If you stick your money into a Roth account, you will have to pay taxes on your earned income. You will not have to pay any taxes on gains/dividends compounded into the future.
  2. Later (sometimes decades later): If you opt to invest in a tax-deferred account, you will save money today because you won’t pay any taxes. You will have to pay taxes later on after deferring any payments until you withdraw. The Tax Man comes for us all!

What is the best option for you?

Generally, this all depends on your tax bracket.

When you are younger or just starting out in your profession, you aren’t making as much money as you might expect to be earning the future.

In that case, you would opt to pay taxes today in order to minimize the taxes you will pay in the future. That is what a Roth account is for.

If you are making a lot of money today but believe you won’t be earning as much as you enter retirement, it might be smarter to try to max out your 401(k) instead.

As always, this is all what makes personal finance so personal. I can’t tell you specifically what to do. There is a general step-by-step roadmap included at the bottom of this post. However, you may read through it and decide that maxing out your 401(k) might be your best bet. Or you may work for a company that doesn’t offer a 401(k) at all.

Do what works best for you. Save some percentage of your present money for your future self, but try to strike a balance with making yourself happy today. That is truly what being wealthy is all about.

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Check out the ongoing, full retirement ladder here:

Step 0: Create a budget that helps you get wealthy

Step 1: Why building an emergency fund is so important for your nest egg

Step 1.5: What type of account is best for your emergency fund?

Step 2: Contribute to your 401(k) up to the company match

Step 2.5: How should I pick the best 401(k) investments for me?

Step 3: Pay off all high-interest debt as aggressively as possible

One Comment

  1. Fredrika said:

    In Sweden, we have retirement schemes, but with an age cap on when you can take out the money, which is quite a downside if you are looking to retire early.
    Currently on the track to looking into if I can tweak my strategy to adjust to this.
    Thanks for an interesting post!

    http://www.fireviking.wordpress.com

    November 22, 2017
    Reply

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