Delaying, or deferring, when you pay income tax on the earnings of an
investment has always provided a means to earn interest on your interest. The
coming reduction in income tax rates can make this concept even more
powerful.
Ways to Defer Income Taxes
The simplest ways to take advantage of tax deferral are with qualified
retirement plans (such as a 401(k) plan or with an IRA. For purposes of
discussing tax deferral, let us ignore the potential additional benefits of
any tax deduction you may get for contributions. Other ways to defer taxes
include annuity contracts and even with stock investments.
How Tax Deferral Works
IRA contributions are the simplest to demonstrate. Let us compare the
difference between making $3000 annual contributions to an IRA with saving
the same amounts in a taxable savings account. We will assume that both
accounts earn 6% annually. For the savings account, the values are after
taxes of 28%.
| Year |
Total
Contributions |
IRA Value |
Savings Account
Value |
| 1 |
$3,000 |
$3,000 |
$3,000 |
| 2 |
$6,000 |
$6,180 |
$6,129 |
| 3 |
$9,000 |
$9,551 |
$9,394 |
| 4 |
$12,000 |
$13,124 |
$12,800 |
| 5 |
$15,000 |
$16,911 |
$16,353 |
| 6 |
$18,000 |
$20,926 |
$23,926 |
| 7 |
$21,000 |
$25,182 |
$23,926 |
| 8 |
$24,000 |
$29,692 |
$27,959 |
| 9 |
$27,000 |
$34,474 |
$32,168 |
| 10 |
$30,000 |
$39,542 |
$36,557 |
| 15 |
$45,000 |
$69,828 |
$61,519 |
| 20 |
$60,000 |
$110,357 |
$92,359 |
| 30 |
$90,000 |
$237,175 |
$177,537 |
| Taxes Due |
|
- $41,209 |
None |
| Net After Taxes |
|
$195,966 |
$177,537 |
Tax Deferral Works
Continuing to earn returns on funds that would have otherwise been paid in
taxes enables your funds to grow faster and to accumulate to a greater
amount. This chart reflects the income tax rates to be in effect as a result
of the 2001 and 2003 Tax Laws. You should also know that the higher the
earnings rate, the more tax deferral works to your benefit.
