Some of the tools that are mentioned during retirement or estate planning will refer to a contribution being “tax deferred” as a benefit. But what exactly does this mean?
Tax deferred normally means that you will not pay a tax now, but will later. This phrase is commonly used when discussing various retirement plans. For example, an employer-sponsored 401K plan is considered tax deferred. When money is taken from your paycheck and put into your 401K account, that is income that is not taxed at that time. It is, however, taxed as income when you receive distributions from your 401K account during retirement.
So what is the benefit of a tax deferred retirement account when you have to eventually pay the income tax anyway? The benefit comes with the assumption that you will be making less money in your retirement years, and thus will have that money taxed at a lower rate.
If you make a $4000 contribution towards a 401k retirement plan this year, your current taxable income for the year will be reduced by that amount to $50,000 – $4000 = $46,000. If you are in the 25% tax bracket, you have lowered your current taxes from $12,500 to $11,500.
Now, at the age of 65, you take that $4,000 as a distribution. Assuming you are now in the 15% tax bracket, you will be paying $600 in taxes vs. the $1,000 you would have paid in earlier years.
While in the example this is a $400 savings in taxes, consider the savings realized on the entire account, not to mention the earnings that have compounded through the years.
Knowing the terms used in both retirement and estate planning can help you make the right decisions. Working with an estate planning attorney not only presents options that meet your specific needs, but presents them in an understandable manner with the advantages and disadvantages and the opportunity to ask questions.