Tax-deferred investment accounts are powerful tools for investors looking to minimize their tax burden while growing their wealth. Contributions to these accounts can help investors delay paying taxes on earnings until funds are withdrawn, often during retirement when they may be in a lower tax bracket. Here are three practical examples of tax-deferred investment accounts:
A Traditional IRA is a popular account that allows individuals to save for retirement while deferring taxes on their investment gains.
In this scenario, consider Alex, a 35-year-old software engineer. Alex contributes $6,000 annually to his Traditional IRA. The contributions are tax-deductible, meaning they reduce his taxable income for the year, which can lower his overall tax bill.
Assuming a consistent annual return of 7%, after 30 years, Alex’s investment could grow to approximately $576,000.
Upon retirement at age 65, when Alex begins to withdraw funds, he will pay income taxes at his current rate on the distributions. This strategy not only helps Alex save for retirement but also allows him to benefit from tax-deferred growth throughout his investment horizon.
Notes:
The 401(k) plan is an employer-sponsored retirement account that provides tax advantages to employees.
Let’s look at Maria, a 40-year-old marketing manager who participates in her company’s 401(k) plan. Maria contributes 10% of her salary, which is $60,000 annually, totaling $6,000 each year into her 401(k). Her employer matches 50% of her contributions up to $3,000.
This means that Maria not only benefits from her own contributions but also receives an additional $3,000 from her employer, effectively increasing her annual contribution to $9,000. Over 25 years, assuming an average annual return of 6%, her 401(k) could grow to about $575,000.
When she retires and starts withdrawing from her 401(k), she will owe taxes on the distributions, but her contributions have grown without being taxed during the accumulation phase.
Notes:
An HSA is not only a tool for managing healthcare costs but also serves as a tax-advantaged investment account.
Consider Jordan, a 30-year-old who has a high-deductible health plan (HDHP) and contributes $3,650 annually to his HSA. Contributions are tax-deductible, and the account grows tax-free. Jordan invests his HSA funds in a diversified portfolio of stocks and bonds.
Assuming an average annual return of 5% over 30 years, his HSA could grow to about $290,000, which can be withdrawn tax-free for qualified medical expenses at any time. If he doesn’t use the funds for medical expenses, he can withdraw them penalty-free after age 65 for any purpose, with only income tax owed on those amounts.
Notes: