Various Investment Options Defer Tax and Generate More Potential Income

“Time is money” is a neat summation of tax-deferred investment accounts. Discover how to generate these savings and why the longer investors wait, the better.

Taxes are typically inevitable. However, there are ways to delay the inevitable and accumulate more significant wealth in the process. Tax-deferred investments take several forms which allow investors to delay the receipt of profits—and taxes—from investment options or designated accounts.

Since tax will only be applied when an individual cashes in their investment or withdraws from their account (usually), those funds that go untouched may accrue gains while avoiding the IRS. Many of the options to create a tax-deferred account carry a withdrawal penalty, so it’s in the best interests of investors to hold off for as long as possible before tapping into that wealth.

It’s more costly to withdraw from a tax-deferred account before the age of 59.5 since that withdrawal is viewed as ordinary taxable income. The IRS penalty is currently 10 percent of the distribution, which can only be avoided under specific exceptions.

In addition, many high-net-worth individuals may find themselves in a lower tax bracket in the future, making the latter a more cost-efficient time to withdraw from a tax-deferred account.


The available options to generate tax-deferred savings

An IRS-qualified tax-deferred savings plan such as a 401(k)/403(b)/457 or an IRA are the most common examples of these accounts. These options offer a further saving beyond their tax-deferred status since contributions to both 4-0 types and IRAs are deducted pre-tax from gross annual income (with the exception of Roth IRAs), which lessens income tax.

IRAs: Deciding which type suits you best

Individual retirement accounts come in four forms: traditional (standard), SIMPLE, Roth, and SEP.

The traditional option can be used by any individual and allows a certain tax-deductible amount (currently $6,000 or $7,000 if you’re 50 or older) to be saved and invested every year.

In contrast, the Savings Incentive Match Plan for Employees (SIMPLE) type is employer-sponsored. It can be implemented as a retirement benefit by employers with less than 100 employees. Other key differences are the contribution maximum and the terms of these contributions: “Employers can choose to make a mandatory 2% retirement account contribution to all employees or an optional matching contribution of up to 3%. Employees can contribute a maximum of $12,500 annually in 2018; the maximum is increased periodically to account for inflation.”

Contributions to Roth IRAs aren’t pre-tax like they are with other versions, but qualified distributions (those made after the required age) are tax-free and have two rules attached. The distribution must occur no less than 5 years after the account was created and the account holder must be 59.5 years old or older. If the age requirement is not met, the account holder must:

  • Have a disability or
  • be using the funds for a qualified purchase orin
  • the distribution is going to the Roth holder’s beneficiary following their death.

Again, any distribution that doesn’t fit these rules will involve paying a 10 percent penalty and the level of tax relevant to the owner’s bracket. Contributing to a Roth IRA is not possible if your income is too high, but traditional IRAs can be converted to a Roth. While taxes must be paid on the wealth converted, there will be zero income tax come retirement.

SEP (Simplified Employee Pension) IRAs allow business owners to institute tax-deferred retirement plans for both themselves and their employees—and the employer must contribute an equal proportion of the employees’ pay to the proportion they contribute for themselves. They are otherwise similar to traditional IRAs, except the contributions can be roughly 10 times as much per year.

Once this plan is established, each employee has ownership and control of their own SEP-IRA which can be maintained alongside another retirement plan with the proper administration.

Alternative tax-deferred options

Life insurers offer fixed or variable rate tax-deferred annuities as other options. These allow investors to place funds into a long-term account which will pay out in regular installments after retirement. These accumulation accounts generally go the fixed-rate route with a minimum guaranteed interest rate that can remain in place for up to 10 years regardless of market performance.

This method is subject to the same age and penalty limitations (59.5 years and 10 percent) for early withdrawal as non-insurance options, with withdrawals usually limited to once per year. There may also be a limit placed on annual contribution amounts if the account holder is older than 50.

U.S. Series EE and I Savings Bonds can also enjoy tax-deferred interest in whole or in part, providing funds are used for educational purposes (with other qualifying criteria). These bonds also go one better than tax-deferral by being tax-exempt at the local and state level. Taxes on the interest income can be deferred after issue for up to 20 years with Series EE bonds and up to 30 years for I bonds, or until the bonds are redeemed by selling them back to the government.

Using non-qualified options for tax deferral

Non-qualified plans are more exclusive tax-deferred arrangements made between an employer and an employee. These options are usually available to key employees as a means to boost retirement income or entice them to either join or remain with an employer. “Non-qualified” refers to their lack of regulation by the Employee Retirement Income Security Act (ERISA) as opposed to the 401(k)s and 403 (b)s which ERISA does oversee.

Contributions to these plans come from either the employer (as with a salary-continuation plan) or the employee (in the case of a deferred compensation plan). Contributions to non-qualified accounts derive from post-tax income, which means while the gains can be tax-deferred, contributions unfortunately won’t reduce taxable income. Both salary-continuation and deferred compensation options can be held alongside a standard 401(k).

As with the other options above, a deferred compensation plan has a 10 percent penalty on distributions made prior to 59.5 years of age. If left untouched, the employer will invest the sum set aside for access in retirement. Such plans must be well-monitored since they can decrease as well as increase in value before they’re accessed.

Tax-deferred options do have one unavoidable risk—and that’s the possibility of the owner’s tax bracket being equal to or higher than their current one when they retire. Retirement doesn’t always mean a reduction in income. But the opportunity to keep more funds invested and generating returns or interest results in the money growing far more than it otherwise would. And any employer matches in certain plans vastly sweeten this return.

Lindberg & Ripple offers customized wealth management, investment, and insurance solutions to wealthy families and successful businesses. We help our clients craft a comprehensive wealth planning model to achieve their financial goals with minimum fuss and maximum savings. To learn more, connect with us.

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