When it comes to paying taxes, it is always nicer to pay less or get a refund. One way to decrease one's income tax burden from year to year is to defer taxes by investing in a 401(K) or IRA.
The way these accounts work is that money is put into them untaxed, allowing them to grow in various kinds of funds. When money is withdrawn in retirement, taxes are taken out as well. Those who withdraw more will be taxed at a higher rate while those who withdraw less will fall into a lower tax bracket.
Deferred Taxes is not the Same as Tax-free
Some investors become confused when they are sold on investing into a 401(k) or IRA. They hear that they'll invest before taxes and that the money will grow tax-free. What they may fail to realize is that they'll be taxed later, leaving their $1,000,000 nest egg to be worth possibly half that much depending on their method of withdrawal and the current rate of taxation on that level of income.
Deferring Taxes Could Lead to a Tax-free Investment
Currently, there is a bill in the US House of Representatives known as the FairTax, or HR 25. It is a proposition to reform the US tax law in its entirety moving from a system of taxing people for their income (as well as payroll, spending, property....) and moving to taxing them on what they consume.
If this bill becomes law and people will only pay taxes when they buy things. Everyone who is currently deferring taxes will do so forever, gaining an incredible advantage in retirement compared to those who invested in ROTH IRAs and other types of post-tax retirement funds.
How Deferring Taxes Works
If an investor earns $90,000, he will fall into the 28% tax bracket (for 2010). When he sets aside 10% of his income for retirement, he will not only add $9,000 to his investment fund, but he will also fall into a lower tax bracket since this money is treated as though he's yet to earn it.
When it comes to filing his taxes he will have had $25,200 (28% of $90,000) withheld from the federal government for income tax collection, but he only should have had $20,250 (25% of $81,000) taken out. The net result will be $9,000 growing for retirement and a tax refund of $4,950.
When taxes are deferred for investment purposes investors win in retirement and at tax time. And they may win big later on if the income tax is abolished.
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