Generally, when it comes to investing for
retirement, you have two options — making taxable investments
or putting money into tax-deferred accounts.
With taxable investments, you owe tax each year on any dividends or interest the investment pays,
but no tax on any increase in an investment’s value until
you sell and realize a profit.
With
tax-deferred
accounts,
you postpone paying income tax on earnings until
you withdraw money from the account.
The tax-deferred advantage
Tax-deferred investments give you a jump-start
on building your retirement assets. Instead of having to pay federal,
state, and sometimes local taxes on your earnings every year,
your investment
compounds
untaxed. Compounding is what happens when your investment earnings
are added to your principal, forming a larger base on which earnings
may accumulate. As your investment base gets larger, it has the
potential to grow faster.
For example, let’s say you invested
$200 a month for 30 years in a hypothetical tax-deferred
account providing an 8% annualized return. You would
have accumulated $352,138 before taxes on an investment
of $72,000. You could withdraw about $3,000 a month
for the next 20 years before you began to use up your
assets, assuming your account continued to grow at
the same rate.
