As an investor, you may sometimes feel frustrated. After all, your portfolio seems to be at the mercy of the financial markets, whose volatility is beyond anyone's control. Yet you can control the quality of the investments you own and the diversification of those investments to improve your chances of attaining your long-term financial goals. One way in which to do so is to put as much as you can afford, year after year, into tax-deferred investments.
When you contribute to a tax-deferred account, your money has the potential to grow faster than it would if you placed it in a fully taxable investment — that is, an investment on which you paid taxes every year. Over time, this accelerated growth can add up to a big difference in your accumulated savings. For example, if you put $200 each month into a taxable investment that earned a hypothetical 7 percent a year, you'd end up with about $325,000 after 40 years, assuming you were in the 25 percent federal tax bracket. If you put that same $200 per month into a tax-deferred investment that earned the same hypothetical 7 percent a year, you'd accumulate about $515,000 — or nearly $200,000 more than you'd have with the taxable investment.*
Of course, you will eventually have to pay taxes on the tax-deferred investment, but by the time you're retired, you might be in a lower tax bracket. Furthermore, depending on how much you choose to withdraw each year from your tax-deferred account, you can have some control over the amount of taxes you'll pay.
Clearly, tax deferral can be a smart choice, but what sort of tax-deferred vehicles are available?
One of your most attractive choices will be your employer-sponsored retirement plan, such as a 401(k). Your earnings have the potential to grow on a tax-deferred basis, and since you typically fund your plan with pre-tax dollars, the more you put in, the lower your annual taxable income. If you're lucky, your employer will even match some of your contributions. Consequently, it's almost always a good idea to put in as much as you can afford into your 401(k), up to the contribution limits, and to boost your contributions every time your salary increases. In 2012, you can contribute up to $17,000 to your 401(k), plus an additional $5,500 if you're 50 or older.
Even if you participate in a 401(k) plan, you can probably also contribute to a traditional IRA. Your earnings have the potential to grow tax-deferred and your contributions may be tax deductible, depending on your income level. In 2012, you can put in up to $5,000 to a traditional IRA, or $6,000 if you're 50 or older. (If you meet certain income guidelines, you might be eligible to contribute to a Roth IRA, which offers tax-free earnings, provided you don't start taking withdrawals until you're 59-1/2 and you've had your account at least five years.)
Finally, if you've "maxed out" on both your 401(k) and your IRA, you may want to consider a fixed annuity. Your earnings grow tax-deferred, contribution limits are high, and you can structure your annuity to provide you with an income stream you can't outlive.
The more years in which you invest in tax-deferred vehicles, the better. So start putting the power of tax deferral to work soon.
*This hypothetical example is for illustrative purposes only and does not represent a specific investment or investment strategy.