Tax Deferral as an Investment Strategy
Deferring taxes is the term which means that you get to pay your income tax later for some amount of money that you invest at present, it is an investment strategy. Deferring taxes is advantageous as you can make some money for investing at the present time.
For example, you are able to deduct $1000 from your taxable income in the present year and then you invest that exact amount into an account that pays you an interest, therefore you will be able to pay around $200 less in income tax for that year. As a result of this, you are gaining $200 extra as compared to if you had not invested the $1000. Therefore if you add the invested amount with the deferred amount, you are making around $1200 more which is growing as an investment for you. There is also another tax deferral strategy that investors often go for; they defer the tax they have to pay for the interest they are earning. The invested amount thus becomes taxable, but the interest becomes tax free.
Another type of tax deferral used by investors is the deferment of taxes paid on interest earned. The dollars invested have already been taxed, but any interest earned is tax free.
Investment Vehicles Tax deferred accounts shelter your money from taxes until you begin making withdrawals in the later part of your life, when you’re likely to be in a lower tax bracket. The type of investment vehicles best for you depends on your situation.
The plan 401(K) is an investment plan that you could opt for. This is however one of the plans that are available only to those employees whose employer makes provisions for it. Such a plan will let you make contributions on an yearly basis which is deductible by tax and grows as deferred tax until you start withdrawing from that account. Your 401(K) plan might come with a bonus, if your employer agrees to add to your account on a yearly basis. Therefore you could make anywhere between 25%-100% on the invested money if your employer matches it as well.
This plan helps you to contribute a larger amount to your retirement plan than any other such plan. You can contribute up to $9,500 and your employer can match that with up to $30,000 annually. You can also arrange for the bonuses that you receive to be directly added to this plan to help grow your investment money faster. If you wish to retire from the job or plan on acquiring more freedom with the kind of investment you make, you could easily roll over your assets into an IRA. The 401(K) plan is the best suited for the newbie at investing and those who do not know where and when to invest their money in.
A 401 (K) may work for a beginner at investing, someone who does not know how to invest in stocks or which are the best stocks to invest in.
Another type of plan offered by an employer is the 403 (b). This plan is for public school and non-profit organization employees and it is tax deductible and tax deferred. You can contribute up to $9,500 of your annual gross income each year to this plan.
However, with the 403(b) plan, you need to beware of some risks. The money you contribute is usually invested in an annuity that is sheltered from tax, but this will have high sale charges and their rates will not have much guarantee.
Anyone with earned income, and the non-working spouse of anyone with earned income, can open up their own IRA and contribute up to $2000 a year. Your accrued earnings are not taxed until you begin withdrawing money from the account. However, withdrawals cannot be made without penalty before age 59 ..Even if your contributions do not qualify for a tax deduction, your earnings are still tax deferred.
The type of investments you can make with your IRA dollars depends on the custodian, but you generally have many more investment options with an IRA than you do with any of the employer sponsored investment plans.
The Keough Plan is another such plan that is available for people who are self employed or who work for businesses that are unincorporated. Under this plan, you get to contribute up to 25% of your income every year with a maximum of up to $30,000. You can contribute most with this plan than any other IRA plan, and all your earnings become tax deductible and tax deferred. There are options to choose from in this plan, that is, you could choose to pay according to a fixed percentage every year or a variable percentage or a fixed amount. A lawyer should be best able to guide you in what suits you the best.
The SEP or the Simplified Employee Plan is the other type of vehicle which is open to only those companies that have less than twenty five employees. According to this plan you can contribute up to $7,000 yourself and your employer can contribute the rest with the maximum of $30,000. However, at least half of the employees of the company must participate in the plan for it to function.
All the above described investment vehicles fall under one of these two categories: Qualified or Non - Qualified plans.
The 401 (k) and 403 (b) plans are qualified plans. Qualified plans are employer-sponsored plans that provide good benefits but that are restricted to the types of investment options offered by the employer. As we already mentioned, 403 (b) plans often require you to invest your money in tax sheltered annuities. 401 (k) plans generally offer a broader range of conventional investment options, but still seem very limited when compared to non-qualified plans. You usually get to select from a preset choice of investment options such as fixed interest annuities, money market funds, stock in your company, and other traditional investments.
The second category of retirement plans is nonqualified plans. Nonqualified plans generally allow more freedom as to when, or if, a contribution has to be made, and they also offer more latitude in the type of investments that can be made. All IRAs fall into this category. Generally, investors have more control over their investments in a nonqualified plan than with a qualified one. Usually they are easier to work with, have less regulation, and require less reporting. Often, contributions to these plans can be deducted as a business expense.
Most investments made with the vehicles we have been discussing fall into one of two asset categories: The first is debt and the second is equity. As an investor, you are either an owner or a creditor. Equity owners are entitled to all free cash flows that exceed the debt payment obligations of the underlying economic entity. Creditors receive priority in agreed-upon future interest and principal payments.
When choosing a retirement plan, you want to be certain of the types of investments permitted with your plan. Do not open an account that does not give you the freedom to choose your own investment options, whether they are debt or equity investments.
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