Investing For Your Future

Unit 7: Tax-Deferred Investments

Constance Y. Kratzer, Ph.D., New Mexico State University

This unit discusses different plans for investing money and deferring the taxes on investment earnings until a later date. Tax reduction is not the primary criterion for choosing investments, but it certainly is an important one. Tax-exempt or tax-deferred refers to the tax status of the earnings on an investment. Although these terms sound similar, they are quite different. Understanding how taxes affect different investments will help you to choose the investments that are best for you.

If no taxes are owed on money you earn from an investment, it is in the tax-exempt category (a.k.a. tax-free). An example of a tax-exempt investment is municipal bonds. The interest only (not any capital gains) from these investments is free of federal taxes, as well as state and local taxes, if the investor lives in the state that issued the bond. For other examples of tax-exempt securities, refer to Unit 5, Fixed Income Investing.

With a tax-deferred investment, taxes are not owed on the investment until it is sold; i.e., taxes are deferred until that time. This unit focuses on the plans available for investing on a tax-deferred basis. Upon completion of this lesson, you will be better able to recognize the benefits and drawbacks of tax-deferred investments. You also will be knowledgeable about various options for tax-deferred investments. After determining which plan is right for you, you will need to select investment product(s) to be included in the plan. Units 4, 5, and 6 provide information about the characteristics of various investment products, such as stocks, bonds, and mutual funds.

One of the best ways to save for retirement is through tax-deferred investments. Contributions (money added to an investment plan) to employer retirement plans and some IRAs can be made with pre-tax dollars (i.e., income you don’t have to pay tax on), allowing you to defer taxes until you start making withdrawals. Tax-deferred investing allows you to keep money that would have been paid in taxes at the time you earned the money, leaving a greater amount available for investing.

Common Advantages of Retirement Accounts

 A major advantage of tax-deferred investing is making contributions to a retirement account with pre-tax dollars. In many instances [e.g., 401(k) plans], the government allows taxable income to be reduced by the amount of the contribution to a tax-deferred retirement plan. As a result, you can have the same amount of money in your pocket and invest what you would have paid the government. For instance, if you are in the 25% marginal income tax bracket and you contribute $1,000 to a tax-deferred retirement plan, you would lower your federal income taxes by $250 (0.25 times $1,000). The savings is based on your marginal tax rate, i.e., the rate you pay on the highest dollar of earnings.

There are six different tax rates in 2008-- 10%, 15%, 25%, 28%, 33%, and 35%. The higher your marginal tax rate, the more you, as an investor, benefit from pretax dollar contributions and tax-deferred earnings. Figure 1 shows the 2008 tax rate schedules for your reference in determining marginal tax rates. These figures are adjusted annually for inflation. 

Figure 1. 2008 Tax Rate Schedules

Single—Schedule X

Taxable Income Over But Not Over Marginal Tax Rate
$ 0   $ 8,025  10%
     8,025    32,550  15%
   32,550    78,850  25%
  78,850  164,550  28%
 164,550  357,700  33%
 357,700 ————  35%

Head of household—Schedule Z

Taxable Income Over But Not Over Marginal Tax Rate
$0  $11,450  10%
   11,450    43,650  15%
   43,650  112,650  25%
 112,650  182,400  28%
 182,400  357,700  33%
 357,700 ————  35%

Married filing jointly or Qualifying widow(er) - Schedule Y-1
Taxable Income Over But Not Over Marginal Tax Rate
$0 $ 16,050 10% 
 16,050  65,100  15%
 65,100  131,450  25%
 131,450  200,300  28%
 200,300  357,700  33%
 357,700 ----  35%

Married filing separately - Schedule Y-2

Taxable Income Over But Not Over Marginal Tax Rate
$0 $8,025  10%
 8,025 32,550  15%
32,550 65,725  25%
65,725  100,150   28%
100,150 178,850  33%
178,850 ----  35%

 

A second advantage of tax-deferred investing is that earnings grow faster because they aren’t taxed until withdrawn. Instead of paying tax on the interest earned, it continues to compound until the investment is sold. Over time, the gap between the value of a taxable and a tax-deferred account, earning the same rate of interest, increases sharply. See Figure 2 for an example.

Figure 2. Comparison of a Tax-Deferred Retirement Investment with a Nontax-Deferred Investment. This figure assumes an investment of $2,000 of before-tax income on an annual basis in a retirement account where those contributions are fully tax-deductible versus investing $2,000 of before-tax income on a non-tax-deferred basis. A 9% annual return is assumed on both investments, with the investment earnings in the tax-deferred account not being reduced by taxes, and the earnings in the other account being taxed annually. A marginal tax rate of 31% also is assumed. Source: Keown, A.J. (2000) Personal finance: Turning money into wealth. Upper Saddle River, New Jersey: Prentice-Hall.

Penalties for Early Withdrawal

 All tax-deferred accounts carry a penalty for withdrawing the money before age 59½. However, some types of accounts have exceptions, such as money withdrawn to be used to buy a first home, or if the owner of the account becomes disabled or dies. In addition, for some accounts, the penalty may not apply if the individual is taking equal periodic payments over his or her life expectancy for at least five years or until age 59½, whichever comes later, or for college expenses, and certain medical expenses. The penalty is usually 10% of the amount withdrawn and then, of course, federal and state income taxes also have to be paid on the withdrawal.

Types of Retirement Plans

 The government allows several different types of tax-deferred retirement programs. Among these are employer-sponsored plans, plans for self-employed persons, and individual retirement accounts (IRAs). Many of the plans are named for sections of the tax code that establish these plans, [e.g., 401(k) and 403(b)]. These plans differ in who is eligible to participate, administrative responsibilities, allowable contribution limits, the types of investments available in the plan, and tax consequences and penalties for early withdrawal (a 10% penalty, plus ordinary income tax, is charged for withdrawals made prior to age 59 1/2; certain exceptions apply).

Employer-Sponsored Retirement Plans

 Salary-reduction plans allow employees to deposit, through payroll deduction, part of their salary into a retirement account. There are a number of ways you, as an employee, can invest on a tax-deferred basis so that your investment will grow free of taxes and will not be taxed until you start making withdrawals. Types of employer-sponsored retirement plans include:

401(k)—A retirement plan for employees in private corporations which defers the taxes on employee contributions and earnings on these contributions until retirement withdrawals are made. The 2007 limit on the amount that can be contributed from income before taxes is $15,500 ($20,500 for workers age 50 and over). Contributions are deducted directly from your paycheck (e.g., 5% of your salary). Some employers contribute a match or a percentage of your contribution. Many companies also allow their employees to borrow up to one-half of the funds from their 401(k) plan for any reason. Interest paid by the employee on the money that is borrowed from his 401(k) is paid into the employee’s own account.
403(b)—A tax-deferred retirement plan that is similar to corporate 401(k) plans. A big difference is fewer employers match contributions because participants are often public (read: taxpayer-funded) employees. 403(b) plans are available to employees of schools and non-profit organizations. The 2007 limit for contributions is $15,500 ($20,500 for workers age 50 and over). The mix of available investment choices differs among institutions. Many allow participants to borrow from their account and have a catch-up provision if you have not contributed fully in the past.
Section 457—This plan is similar to the 401(k) and 403(b) but is for state and local government employees. With Section 457 plans, employer matching is virtually non-existent. The 2007 limit that you can contribute is $15,500 ($20,500 for workers age 50 and over).

Note: Contribution limits for all of the employer plans listed above will be adjusted for inflation in 2007 and thereafter. The Pension Protection Act of 2006 made permanent these increased contribution limits and catch-up contributions for individuals age 50 and older that were originally set to expire after 2010.

 

Self-employed or Small Business Retirement Plans

 There also are tax-deferred plans available to individuals who are self-employed or employees of small businesses. These include:

bullet Keogh plans

bullet Simplified Employee Pension Plan (SEP)

bullet Savings Incentive Match Plan for Employees (SIMPLE).

The following descriptions can help determine which plan could work for you.

Keogh Plan

 Named after U.S. representative Eugene James Keogh, who first introduced the idea in 1962, this plan is available to anyone who has self-employed income. This is generally income from any unincorporated business that you conduct, whether it is your primary job or a business "on the side." Self-employed persons may contribute as much as the lesser of 100% of compensation or $40,000, starting in 2002, with periodic adjustments for inflation. For purposes of a Keogh, the definition of earned income is net profit (i.e., net income after subtracting business expenses). The money contributed to a Keogh plan is not taxed and grows in value until it is withdrawn. You may have both a Keogh plan and an IRA. If you work for an employer and are self-employed on the side, you may pay into a Keogh and also belong to the employer’s retirement plans. In addition, if you have employees, you can enroll others who work for you.

To set up a Keogh plan, you must first select a bank, mutual fund, or other financial institution. Usually they will supply the needed paperwork and provide you with a prototype plan. You will be asked to choose a defined-contribution and/or a defined-benefit Keogh plan. These two options are not mutually exclusive—your plan can include both. There are three forms of defined-contribution Keogh plans:

1. A money-purchase Keogh requires you to choose a fixed percentage of your earnings and contribute that percentage every year to the plan.

2. A profit-sharing Keogh allows you to contribute a fixed percentage of business profits. You can contribute the full amount one year and less or nothing the next, depending on how the business does.

3. A combination of money-purchase and profit sharing offers the option of contributing up to the maximum allowed, but doesn’t lock a business owner into high payments.
Under a defined benefit Keogh plan, rather than contribute a percentage of your earnings, you are allowed to contribute more than the annual limit imposed on defined-contribution plans. Also, the amount contributed each year can vary greatly. These plans can be complicated and costly to set up and administer because a professional actuary is required to oversee the plan. Generally, defined-benefit Keogh plans are used as a catch-up strategy by older business owners who have put off setting up a retirement plan.

SEP or SEP-IRA (Simplified Employee Pensions)

 Simplified Employee Pensions (SEPs) allow business owners to make contributions to their own individual retirement account (IRA) and the IRAs of their employees. Certain dollar limits and percentages of pay apply.  Employers must contribute the same percentage to their employees’ IRA as they do to their own. One advantage to the employer or self-employed person is that contributions do not have to be made every year. Little paper work is required, it is much simpler than setting up a Keogh plan, and does not have the reporting requirements of a Keogh. A disadvantage is that you cannot contribute as much to a SEP as you can to a Keogh plan. Generally, contributions are made by the employer and are tax-deductible to the employer.

SIMPLE Plans

 A SIMPLE plan is a tax-deferred savings plan that can be set up by owners of a business that employs 100 or fewer employees to cover all employees and themselves. As of 1997, small employers can establish SIMPLE-IRAs or SIMPLE 401(k)s. To be covered, employees must earn at least $5,000 a year. The maximum annual contribution in 2005 was $10,000. In 2006 and later, the contribution limit will be adjusted for inflation. The employer can match up to 3% of the employee’s compensation. 

The employee’s contribution reduces taxable income and the employer’s contribution reduces the business’ taxable income. A SIMPLE-IRA is owned by the employee and belongs to the employee, even if employment is terminated. The employer can’t sponsor another retirement plan in addition to a SIMPLE.  Like SEPs, SIMPLE-IRAs have low administrative responsibilities and costs compared to Keogh plans.

Individual Retirement Accounts (IRAs)

 For individuals who qualify, another smart way to build a retirement nest egg is to take advantage of the tax-deferred growth offered by an Individual Retirement Account (IRA). An IRA is a personal retirement savings plan, which may be set up with banks, mutual fund companies, brokerage firms, or similar investment organizations. Three types of IRAs are described below:

Traditional IRAs

For tax-deferment purposes, an IRA can be funded until April 15 of the following year (e.g., April 15, 2007 for the 2006 tax year). Of course, the earlier in the year an IRA is funded, the quicker the interest will begin to accumulate.

The maximum that can be contributed in any one year is the lesser of the amount of the annual limit or up to 100% of earned income. Your spouse can do the same. However, you don’t have to have to make the entire contribution all at once. You can start with whatever money is available (e.g., $500) that meets the minimum amount set by a financial institution (e.g., bank or mutual fund). 

The maximum IRA contribution limit is $4,000 for 2005 to 2007 and $5,000 for 2008 and thereafter, to be adjusted for inflation in $500 increments. In addition, people age 50 and over can contribute an additional $1,000 for 2006 and thereafter. The Pension Protection Act of 2006 made permanent these increased contribution limits and catch-up contributions for individuals age 50 and older that were originally set to expire after 2010. Contributions can be made as long as you are under age 70 1/2.

Traditional IRAs may be:

Tax-deductible (for taxpayers who are not participants in an employer retirement plan or plan participants with income below certain levels)

Non-deductible (for taxpayers with earned income who fail to qualify for a deductible IRA).

Deductible IRAs provide a double tax benefit: contributions—and all earnings—are tax-deferred until retirement. You can also deduct (from taxable income) the full amount contributed if you are in an employer-sponsored retirement plan, but your adjusted gross income (AGI) is $50,000 or less if you are single or $75,000 or less if you are married and filing jointly (2006 amounts). Once you reach this level, a phase-out range begins. The deduction is eliminated at a maximum AGI of $60,000 for single filers and $85,000 for married joint filers (2006 amounts).

Figure 3 below shows the increase in income ranges for deductible IRAs between 2003 and 2007.

Figure 3. Phase-out ranges for deductible IRAs.

Year Joint Return Single, Head of Household
2003 $60,000- $70,000 $40,000- 50,000
2004 $65,000- $75,000 $45,000- 55,000
2005 $70,000- $80,000 $50,000- 60,000
2006 $75,000- $85,000 $50,000- 60,000
2007* $80,000- $100,000 $50,000- 60,000

*And later years

The IRS no longer considers one spouse an "active participant" in a retirement plan simply because the other spouse has an employer-sponsored retirement plan. As a result, the spouse who does not have an employer-sponsored retirement plan can make a tax-deductible contribution to an IRA, provided the couple’s AGI is less than $160,000.

If you withdraw money from an IRA before age 59½, there will be a 10% penalty on the amount withdrawn, and federal and state income taxes will be due on the amount withdrawn on that year’s income tax return. You can withdraw funds from an IRA without a penalty after you reach age 59½. Withdrawals from a Traditional IRA are taxable and are treated as ordinary income. Withdrawals must begin no later than April 1 of the year after you turn 70½.

Penalty-free withdrawals of up to $10,000 can be made from any IRA for first-time homebuyers who meet certain qualifications. Withdrawals also can be made for qualified higher education expenses incurred on behalf of the taxpayer, the taxpayer’s spouse, or any of their children or grandchildren. These education withdrawal provisions include expenses related to undergraduate or graduate-level college courses.

Roth IRAs

Although contributions to a Roth IRA are not tax-deductible, qualified withdrawals are tax-exempt if made more than 5 years after the Roth IRA was established and the taxpayer has reached age 59½, becomes disabled, or dies. Roth IRAs accumulate like whole life insurance- they go in after-tax, accumulate tax-deferred, and come out tax-free. Another big plus: Unlike traditional IRAs, investors in a Roth IRA are not subject to the minimum distribution rules, and you can make contributions after age 70½ as a worker or spouse of a worker. Early withdrawals from a Roth IRA are tax-free and penalty-free if they satisfy the five-year holding requirement or the money is used to cover qualified first-time homebuyer expenses of up to $10,000, or if the taxpayer becomes disabled before age 59½ or dies.

Individuals can contribute up to $4,000 per year in 2005-2007, and up to $5,000 in 2008 (to be adjusted for inflation in $500 increments) to a Roth IRA if they have an AGI of up to $95,000 (for married taxpayers filing a joint return, the AGI limit is $150,000). Eligibility for contributing to a Roth IRA in 2007 begins to phase out for individuals with an AGI over $99,000 and ends once an individual’s AGI exceeds $114,000. For joint filers, the phase-out figures are between $156,000 and $166,000. Investors can roll funds over from a traditional IRA to a Roth IRA, provided the taxpayer’s AGI is $100,000 or less and he or she is not a married individual filing separately.  Taxes must be paid on the amount of the conversion, in the year that the conversion is made. To determine if converting from a traditional IRA to a Roth IRA will result in a decrease in taxes, check one of the IRA calculator links on the Web site <www.rothira.com>.

Coverdell  Education Savings Accounts (Formerly Education IRAs)

 The Coverdell Education Savings Account (ESA), formerly known as the Education IRA) allows parents, grandparents, and others to help fund the qualified higher education expenses of a named beneficiary who is under age 18. Annual contributions to Coverdell ESAs are nondeductible. The maximum contribution per child became $2,000 starting in 2002. Also, starting in 2002, the definition of qualified educational expenses expanded to include elementary and secondary schools and contributions are allowed after a child reaches age 18. Coverdell ESA earnings can be withdrawn tax-free if used solely for the beneficiary's qualified education expenses. Any earnings not used for qualified education expenses are included in the gross income of the beneficiary in the year distributed and are subject to an additional 10% penalty tax.

The good news for parents with more than one child is that a tax-free and penalty-free rollover of account balances can be made to a Coverdell Education Savings Account (ESA) to benefit a younger member of the beneficiary’s family. Annual income limits for making contributions apply.

Annuities

 An annuity is a contract between the investor and a life insurance company. All annuities have two things in common:

1. There is no tax deduction for the money used to purchase the annuity (exception: tax-sheltered annuities in 403(b) plans).

2. Inside the annuity, the money compounds tax-deferred. Beyond this, each annuity has its own cost structure, characteristics, and rate of return. Taxes are paid on the earnings when money is withdrawn at retirement, either in a lump sum or as a series of periodic payments.
Annuities are sold by bankers, stockbrokers, financial planners, insurance agents, or through mutual funds, but regardless of who makes the sale, an insurance company always backs the annuity. If the annuity holder (investor) dies during the so-called accumulation phase, that is, before receiving any payments from the annuity, the beneficiary is guaranteed to receive the amount of the original investment.

Investors purchase an annuity by paying a lump sum of money (minimum purchase range from $2,000 to $10,000) or by making deposits over time. An annuity may be either an immediate annuity or a deferred annuity.

Immediate Annuities

 An immediate annuity pays a lifetime income starting now. In return for a lump sum of money, the purchase of an annuity guarantees a fixed stream of income. To determine where to buy the right annuity, check the Annuity & Life Insurance Shopper or Best’s Retirement Income Guide for the companies that pay the five highest monthly incomes per $1,000 invested. Go with a quality company (one that has paid consistently above average returns) that pays the most. To spread your risk, you may want to buy annuities from two or more companies or buy annuities in subsequent years.

Deferred Annuities

 Deferred annuities may be purchased in one of two ways. Single premium annuities are purchased with a lump sum and flexible payment annuities may be purchased by installment payments over a period of years. Deferred annuities accumulate money for the future and come in two types. A fixed annuity pays a specified interest rate for a period of time. A variable annuity puts your money in stock, bond, or money market mutual funds, and returns are dependent on the financial market volatility and performance.

Payout Options

 The payout from annuities may be taken in several ways. Taxes are owed when the money comes out, and there is 10% penalty on earnings withdrawn before age 59½. You can take monthly payments for the rest of your life, or you can make periodic withdrawals. If you make regular withdrawals, part of each withdrawal is treated as taxable income, and the rest is a nontaxable return of your own capital. If you make occasional withdrawals, the entire withdrawal is treated as taxable income. Taxes are levied until you have taken all of the earnings on the original capital invested. Other payment options include taking the money in a lump sum or rolling your savings into another annuity tax-free.

When you buy an annuity, you are making a long-term commitment (15-20 years). Moving the money to another annuity may be difficult, and quitting is expensive. You usually have to pay a surrender fee to the insurance company for selling an annuity too soon (e.g., withdrawing money from an annuity after the third year). A common fee is 7% the first year which is reduced to 0% by the seventh year. Because annuities are purchased with after tax-dollars, it is usually recommended that pre-tax investment plans [e.g., IRAs, 401(k)s] be funded to the maximum first.

Summary

This unit has discussed the advantages of tax-deferred plans to invest for retirement. These include employer-provided plans, small business employer/employee plans, plans for the self-employed, Individual Retirement Accounts, and annuities. Tax advantages are that earnings are not taxed until funds are withdrawn, and contributions are often made with pre-tax dollars that are not subject to income tax. As contributions to some IRAs and annuities may not be with pre-tax dollars, putting the maximum in tax-deferred employer plans first will bring greater returns at retirement.

Keep in mind that there are penalties for early withdrawal on many of the plans, so those dollars that are needed before age 59½ are better invested in other accounts. Also, once you have determined which plan works for you, you still have to decide on what investments you will put in the plan. Other units in this course will help you make those decisions. Start now with the action steps. The sooner you start, the more time your money will have to grow!

Action Steps

Check off the steps after you have completed them.
Ask if your employer has a tax-deferred retirement plan (e.g. 401(k).
Find out what investment choices are available in the employer plan.
Find out if your employer matches your investment dollars and, if so, how much is the match.
Set a date to start contributing or to increase your contribution – either a dollar amount or a percentage of your salary.
If you are self-employed, determine the type of retirement fund you could start, set an amount and begin making contributions.
Check out IRAs – and which type is best for your age and income level.
Increase contributions to your tax-deferred plan each time your pay increases.

 

References

2001 Tax Law Summary (2001). Albany (NY):  Newkirk Press.

Brennan, P. Q. The Ins and Outs of IRAs. Rutgers Cooperative Extension of Morris County.

Garman, E.T. & Forgue, R.E. (2006). Personal Finance, 8 th Edition. Houghton Mifflin Company, Boston.

Goodman, J. E. (1997). Everyone’s Money Book. Dearborn Financial Publishing, Inc.

Keown, A. J. (1998). Personal Finance Turning Money into Wealth. Prentice-Hall, Upper Saddle River, New Jersey.

O’Neill, B.(1997) Investing in Annuities: What You Need to Know, class curriculum, Rutgers Cooperative Extension..

Pond, J. A. (1998). Personal Financial Planning Handbook with Forms and Checklists, Second edition. Warham, Gorham & Lamont: Boston.

Pond, J. A. (1993). The New Century Family Money Book.

Tax Law Highlights (2006). Albany (NY):Newkirk Press.

Tyson, E. (1994). Personal Finance for Dummies. IDG Books Worldwide, Inc. San Tateo, CA.

White, A. (1999). The Basics of Retirement Plans, class curriculum, Virginia Cooperative Extension.

 

Author Profile

Constance Y. Kratzer, Ph.D., is an extension specialist in family resource management, Home Economics Extension Department, New Mexico State University. She received her Ph.D. from Michigan State University in 1991. She provides statewide program leadership in the areas of financial management and management of time and energy. Her research has been in the areas of perception of economic well being, planning for retirement by the self-employed, and workplace financial education. She received an Emerging Leaders Award from Michigan State University in 1996.

For additional information about tax-deferred investing and other topics related to retirement planning, visit Purdue Extension's Planning for a Secure Retirement Web site.

Last updated: March 12, 2007, webmaster@rce.rutgers.edu