HOW RETIREMENT PLANS HELP YOU SAVE ON TAXES
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Tax-deferred means that the earnings that build up in your
retirement plan are not taxed, as in other kinds of investments. Your earnings
are free from taxation while they are in the plan. Once you draw them out, either
at retirement or before, your earnings from these plans may be subject to taxes.
Even though you may have to pay taxes on your retirement plan earnings
when you take them out, you may still pay less than if you had that income taxed
while you were employed. Many people have lower incomes in retirement, which
place them in lower tax brackets.
In addition to savings from tax deferral, some plans allow you
to contribute your income pre-tax, so you don't have to pay taxes on the money
you contribute today (at least, not until you retire). And, with some plans,
your contributions can be taken as deductions from your income for tax purposes.
There is a price to be paid for all this tax freedom, however.
With most plans, any money you take out prior to retirement age can be taxed
at a hefty percentage. There are also limitations to how much you can contribute
to some plans, based on your income or employment status.
This chart shows you a comparison of three investment options:
an after-tax, taxable investment, like a passbook savings account; an after-tax,
tax-deferred vehicle, such as an annuity; and a pre-tax, tax-deferred plan,
such as a 401(k) plan. As you can see, lessening the tax bite creates considerable
extra capital for retirement.
Now let's look one of the most common tax-deferred retirement
plans: the 401(k).