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How to Use a Tax Deferred Savings Plan

By Cassidi Heltcel, CPA

A tax-deferred savings plan can slow the drip, drip, drip of income taxes. Uncle Sam taxes your pay before you draw it. If you are frugal and live below your means and try to save, you are taxed on the interest those savings earn.

The interest on a CD, for example, is ridiculously low to begin with, which is a further disincentive to save.
There are safe and stable alternatives to placing your nest egg in an account whose interest ranges somewhere between paltry and always below the rate of inflation. Those alternatives have the additional benefit of deferred taxes.

Deferred means you don't pay tax on the interest until you enter the distribution phase of the account. The distribution could be through periodic withdrawal or a monthly annuity payment. 

There is a tradeoff in those tax-deferred alternatives, though. A bank account is insured by the government. The 3 tax-deferred savings plans are not insured. The upside of the tradeoff is that tax-deferred savings plans actually earn decent interest, and the interest is insulated against corrosive taxation. 

The government will, of course, get their cut when you begin withdrawing the funds. However, the future time of withdrawal is likely to be when your retirement income puts you in a lower income bracket.
Here are 3 ways you can use a tax-deferred savings plan:

1. Enroll in a 401(k), 403(b), or 457 employer-sponsored salary deferral retirement plan.

When you contribute to one of those plans, the funds go directly from your paycheck, making savings automatic and easy. Contribution limit for 2018 is $18,500 ($24,500 for selected plans for employees past age 50). 

You owe no federal income taxes at the time you contribute to the plan. The taxes are deferred until you begin withdrawing the funds. Also, you can combine those plans with after-tax contributions for a Roth IRA, described below.

2. Sign up for an IRA.

The individual retirement account comes in two flavors: 1) the traditional, and 2) the Roth.

The traditional IRA is a tax-deferred savings plan that gives you an immediate tax deduction equal to the amount you saved. You pay income tax when you begin withdrawing from your account. You cannot raid your traditional IRA until age 59 1/2 unless you're willing to pay a 10 percent tax penalty. You cannot add to your regular IRA past age 70 years 6 months. And you must begin making withdrawals by that same age.

The Roth IRA provides no immediate tax benefit, but your eventual withdrawals are not taxed, and you don't have to start withdrawing the funds until you're ready. 

Maximum contributions for each type of IRA are $5,500 or $6,500 for savers past 50 years old. 

3. Put your nest egg in a tax-deferred annuity.

Tax-deferred annuities are combination savings and insurance plans. They come in a variety of categories and payout schemes. The categories are immediate and deferred. An immediate annuity, where you hand over a one-time principal payment to the insurance company, has no tax-deferred benefits.

The deferred annuity, as its name implies, defers payouts often for many years. While you are investing in the plan during your working years, the fund grows and the interest compounds. Meanwhile, you pay no taxes on the earnings until the annuitized payouts begin.

Then there are fixed and fixed index annuities. Both have tax-deferred advantages. Fixed annuities guarantee a percentage return on the investment. Fixed index annuities earn interest based on the performance of the financial market investments of the insurance company that sells the product.
Annuities, as insurance products, have provisions for beneficiaries, who inherit both the remaining value and the deferred tax benefits.

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