Tax Deferral for Building Wealth
Like anyone who has been doing something for a long time, I tend to think that everyone knows what I know. I have been in the tax field for several (uh-hum) decades and know the benefit of deferring taxes but I realize that it is not so apparent to others. Trust me. Tax deferral is one of your biggest wealth building friends.
I was working on a client’s tax return the other day and noticed that he had cashed out some of his retirement account. He is not yet 59 ½ which is the magic age for withdrawing from your qualified retirement accounts penalty free. This makes it not only subject to regular tax but also to the 10% penalty for early withdrawal. There was some tax withheld but not enough to cover the tax since he’s in the 33% bracket so with the penalty, is paying a hefty 43% on it. I haven’t broken the news that he owes $25,000 on the return.
Now, it’s one thing if you need the cash, but this guy is not in that situation and I know that if he had any clue as to the tax consequences, he would have called me to discuss before making the withdrawal.
Here’s why deferring tax is so vital to building wealth:
- When you defer taxes, you are saving current taxes/cash (think your 401(k) deduction). Your contributions reduce your taxable wages so it’s a no brainer; Pay yourself and get a tax benefit. The tax savings can be significant because you are saving both federal and state (in most states) taxes. Folks living in the Big Apple are paying over 10% in state and local taxes so that savings can be substantial. Let’s say that you are making $50,000 annually and contribute 10% to your 401(k) so $5,000. You now have a retirement account worth $5,000 and you saved around $1,000 in current taxes if we assume a 15% federal bracket and 5% state. If you earn $100,000 and also contribute 10%, you have an account of $10,000 and probably saved closer to $3,500 in taxes since you would be in a higher tax bracket. See how the savings can add up? It effectively cost you only $4,000 ($5,000 less $1,000) or $6,500 ($10,000 less $3,500) to fund those retirement accounts.
- If the deferral is within a qualified retirement account (401(k), IRA, profit sharing plan, pension plan, etc.), you are saving taxes on the contributions since they reduce your federal taxable wages and also on the earnings on those contributions since earnings on a retirement account are not currently taxable. In other words, you are not reporting any interest, dividends, or capital gains in your tax returns. That is a huge benefit in the long run.
- I always say that a bird in the hand is worth two in the bush. Yes, Roth IRA’s are popular since you contribute with after tax dollars but then (supposedly) are able to withdraw both the contributions and earnings tax free in retirement. There are also less strict rules for making withdrawals before retirement. This can be a good strategy too but the tax laws have changed quite a few times (understatement) in my career so what’s to say that they won’t change down the road and tax your nest egg. The tax rules are not based on fairness but on revenue generation. My point is save the tax dollars now when you know you can!
I hope this helps shed some light on the huge advantages to deferring tax. Let me know if I can help you in any way.
My Best Always,
The above article is for information purposes only and is not to be construed nor relied upon as tax advice.
About the Author
Kimberly Adams is a Business and Wealth Coach, Speaker and Author. She has the unique combination of having spent decades in both the tax and financial world as well as decades devoted to personal growth and transformation with many certifications in coaching, speaking and energy healing