Nobody enjoys losing money to the IRS, and if given the choice, most of us would probably opt to hold off on paying taxes for as long as possible. Thankfully, there's a way to do just that. It's called tax-deferred growth, and it's what enables your investments to grow over time without losing money to the IRS along the way.
Tax-deferred growth is investment growth that's not subject to taxes immediately, but is instead taxed down the line. Perhaps the most common example of tax-deferred growth is that which you'll get in a retirement plan like a traditional IRA or 401(k). Annuities also offer tax-deferred growth, making them a viable though perhaps less popular option for generating retirement income.
Earn now, pay taxes later
Just as the IRS gets a share of the income you bring home in your paycheck, so too does it get a share of the gains your investments bring you. But if you save in a tax-deferred retirement account like a traditional IRA or 401(k), you won't pay taxes up front as you do in your paychecks, or as you would on investments in traditional brokerage accounts that are sold at a profit. Rather, your investments in a traditional IRA or 401(k) can continue to grow year after year, and you won't pay taxes on your gains until the time comes to take withdrawals in retirement.
Imagine you have a year where you make $5,000 in gains in a traditional brokerage account by selling an investment (whether a stock, bond, or shares of a mutual or index fund) for a price that's higher than what you paid for it. You're responsible for paying taxes on that $5,000 when you file that year's return. With a traditional IRA or 401(k), however, that won't happen. Rather, you'll get the option to reinvest that $5,000 and not pay taxes on it until you're older and ready to take withdrawals from your account.
Tax-deferred growth versus tax-free growth
While tax-deferred growth can certainly help you build your nest egg, believe it or not, your savings options get even better than that. If you open a Roth IRA or 401(k) versus a traditional one, your investment growth won't just be tax-deferred. Rather, it will be tax-free. That's because Roth-style retirement plans don't impose taxes on distributions, so once your investments start making money, the associated gains are yours free and clear of taxes provided you don't take your withdrawals too early.
In other words, the difference between tax-deferred growth and tax-free growth is that with the former, you're paying taxes eventually, just not right away. With the latter, however, you're not paying taxes at all. It's for this reason that savers are often encouraged to choose a Roth retirement plan over a traditional one. That said, Roth IRAs come with income limits, so not everyone can contribute to one directly. There is, however, the option to convert a traditional retirement account into a Roth even if you're a higher earner.
Keep in mind that Roth-style retirement plans don't offer an immediate tax break for contributions. With a traditional IRA or 401(k), in addition to tax-deferred growth, your contributions themselves are deductible for each tax year you make them in. This means that if you decide to put $5,000 into either account this year, you'll get to deduct that $5,000 on this year's tax return. If you fund a Roth account with $5,000 this year, that money won't come off this year's return, but you'll get tax-free growth.
Whether you decide to save in a traditional retirement plan or a Roth account, know that you'll be snagging a tax break either way. It's up to you to decide whether you want to enjoy tax-deferred growth and owe the IRS money eventually, or take your tax-free growth and shed that burden completely.
The $16,122 Social Security bonus most retirees completely overlook
If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,122 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how to learn more about these strategies.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!
The Motley Fool has a disclosure policy.