If you haven't retired yet you've probably been told by somebody that you should be putting some of your funds in tax-deferred investments. Yet you may wonder if it is really a good idea to put a large percentage of your income in such vehicles. The truth of the matter is that there are advantages to such instruments but there are also some disadvantages that you should be aware.
Tax-Deferred is Not Tax-Free
The biggest myth about tax-deferred investments such as 401ks, annuities and IRAs is that they are tax free. Nothing could be further from the truth these investments are tax-deferred which means taxes are postponed until you take money out.
If Kermit's federal income tax rate was 25% and he took $10,000 out of his IRA he would have to pay $2,500 of those funds to the IRS. So this money is obviously not tax free. If Kermit were under 59? years old he'd have to pay more because the IRS charges a 10% tax penalty on all funds withdrawn from such vehicles by people under that age. That means Kermit would end up pay $3,500 to the IRS because 10% of $10,000 is $1,000. The 10% penalty is charged on top of your regular taxes.
Now there is another kind of Individual Retirement Account (IRA) or 401k out there called a Roth. A Roth IRA or 401k is not tax deferred it is actually tax free. The drawback to a Roth 401k or IRA is that you have to pay income tax on the funds you deposit at your normal rate. The advantage to this arrangement is that you never have to pay federal income tax on that money again. Unfortunately the IRS will charge the 10% tax penalty on Roth withdrawals for people under 59? years old.
Limitations to Tax-Deferred Investments
There are some serious limitations to tax deferred investments. In most cases people that are under 59? years old will be charged the 10% tax penalty on withdrawals. There are exceptions to this rule, the IRS allows for some hardship exemptions and Tax Sheltered Annuities (TSAs) a special investment available to some government employees and public school teachers are exempt as well.
There is also a limit on what most people can place in tax-deferred investments. Most people will not be able to put more than $1,500 in an IRA or 401k account a year because of federal law. This applies to both employer matches and your regular contributions.
There are some tax-deferred investments that you can put unlimited amounts of money into. There are no limits to the amounts that you can contribute to deferred annuities. Therefore you can put as much as you want in such a vehicle. Unfortunately deferred annuities are subject to the 10% tax penalty for withdrawals by persons under 59? years old.
Life insurance including universal, whole and indexed policies is tax deferred. Life insurance policies are also subject to the 10% penalty for persons under 59?. It can also be hard to get money out of life insurance policies even when they provide cash value.
The bottom line is that tax-deferred investments are not a good deal for most persons under a certain age. People under 45 should only put fund that they know they will not need in the near future in such a vehicle because of the tax penalties. Many people would be better off waiting and putting their funds in a tax-deferred annuity when they get older. They will have to pay taxes on the funds but they can avoid the 10% tax penalty that way.
Steven Hart is a freelance writer and a Financial Advisor from Cary, IL. He writes about Annuity topics like Annuity Calculator, Annuity Interest Rates, and Annuities Good or Bad.
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