Why is tax-deferred investing a big deal?

When you invest for retirement in a tax-deferred account, the tax advantages help boost the power of compounding: You keep what you may earn. Instead of paying a substantial percentage to the IRS immediately, the tax is deferred. And you may reduce your federal income tax bill because you may be able to deduct your contribution.

When your potential investment earnings accumulate free of taxes, 100% of any earnings goes to work for you immediately — and keeps working over the years until you withdraw it. In a taxable account, investment earnings are taxed annually at your federal income tax rate and may also be subject to state taxes. Currently Federal income tax rates range from 15% to 35%. It's not hard to figure that if you had the benefit of investing that extra amount, and enjoyed any additional compounding on the earnings, it may really add up over time.
Depending on the investment plan you choose, the money you contribute toward retirement may be tax-deductible as well. With a workplace retirement investing plan, such as a 401(k), your contribution comes out of your paycheck before taxes are calculated. With a tax-deductible IRA or certain accounts for the self-employed, such as a SEP IRA, you may be able to claim a deduction on Form 1040 for the amount you contribute every year.

The IRS on Hold

Of course, tax-deferred means that the IRS expects to collect its share of your earnings and income at some future date. When you withdraw money from a tax-deferred retirement account, you'll pay federal income tax at your current tax rate and may be subject to state taxes. Because many workers earn less in retirement, it's also possible that withdrawals will be taxed at a tax rate lower than they would have incurred when the money was earned or invested.

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For informational purposes only.

AARP Financial Inc. does not provide tax advice. Please consult a tax advisor for information pertaining to your particular situation.

The information and content provided herein is general in nature and is for informational purposes only. It is not intended, and should not be construed, as a specific recommendation, or legal, tax or investment advice, or a legal opinion. Individuals should contact their own professional tax or investment advisors or other professionals to help answer questions about specific situations or needs prior to taking any action plan based on this information.

The Financial Advisors are investment adviser representatives of AARP Financial Inc., an investment adviser.

While AARP endorses the services provided by AARP Financial Inc., AARP does not offer financial products or services itself and cannot recommend that you or any specific individual should purchase any particular product or service. AARP Financial Inc. is an investment adviser and a subsidiary of AARP.