Tax Deferral"One way Warren E. Buffet became the world's most successful investor was by understanding how putting off tax payments can build wealth." Learning to Think Like Warren Buffett, Business Week, February 14, 2004, p.2
Money that remains inside a savings bond or fixed annuity grows free from current income taxes. Not only does the principal earn interest (simple interest at work), and the interest earns interest (compound interest at work), but the money that would have gone to Uncle Sam also earns interest (tax-advantaged interest at work) TAX DEFERRAL MEANS TRIPLE INTEREST CREDITING
Suppose you had $50,000 and were in a combined federal and state tax bracket of 33%. Say both a taxable account and the annuity or savings bond are earning 6%. The annuity and bond benefit from triple interest crediting and work with the full 6% interest. However, the taxable account produces a Form 1099 every year which says that part of the interest must be paid in taxes, whether it is being used or left for later. If you are earning 6%, but have a 33% tax rate, a third of that 6% - or 2% - goes for taxes. This means there is only 4% working in the taxable account. Here is what the accumulated values of the taxable account and the tax-deferred account look like down the road.
MORE INTEREST INCOME
The tax-deferred advantage continues growing with each passing year. Tax-deferred growth means more money is available for future needs. If you kept earning 6% here’s the interest earned.
Tax-deferral translates into over 20% more interest available to spend in 10 years and an amazing 46% more interest more than the taxable account provides in 20 years. One of the fears in retirement is outliving our money; an annuity can help overcome this fear. Tax-deferral means a higher accumulated value from which to draw.
Tax-deferred doesn’t mean tax free. Taxes have to be paid on the interest when withdrawn or paid out at death.. However, tax-deferral still means more dollars. Let’s look at the previous example and assume the annuity is cashed in and taxes paid. Here’s what we’d have in our hands.* *In addition to regular income taxes there is a 10% penalty on withdrawals from an annuity before age 59 1/2. The penalty only applies to interest earned and doesn’t affect the premium, but withdrawals are taxed on an “interest out first” basis. The penalty does not apply upon the death or disability of the owner, or if substantially equal payments are made. Consult your tax advisor. There are other ways to look at the power of tax-deferral. INTEREST FREE LOAN
If someone said they would loan you $10,000 and that you didn’t have to pay it back for 10, 20 or 30 years and you wouldn’t have to pay any interest on the loan, but you could earn interest on the money. Would you be interested?
Tax deferral this means you are getting to use money that should have gone to pay taxes. Someday, that money has to be paid back. However, you get to keep the after-tax portion of the interest you earned from those tax dollars and, if you’re in a lower tax bracket when you do repay the “loan”, you could pay back fewer of them. Finally, there’s no limit on the amount of taxes or the length of time you can defer, but interest is taxable when withdrawn or at death of the owner. TAX CONTROL
If you have a taxable account every January you receive a Form 1099 that says you must pay taxes on any interest earned, even if that interest is being saved for future use. An annuity or savings bond gives you tax control. You decide when to take the interest and pay the taxes - not the IRS.
If your pension, taxable interest income, tax-free municipal bond interest and social security income is over a threshold amount you can be forced to pay taxes on your social security benefits. However, interest compounding within an annuity is not counted in the calculation. If you move dollars generating compounding interest from a taxable account to an annuity you may lower or avoid SSBT (Social Security Benefit Taxation). AVOIDING SSBT (Social Security Benefit Taxation)If your pension, taxable interest income, tax-free municipal bond interest and social security income is over a threshold amount you can be forced to pay taxes on your social security benefits. However, interest compounding within an annuity is not counted in the calculation. If you move dollars generating compounding interest from a taxable account to an annuity you may lower or avoid SSBT (Social Security Benefit Taxation).
MISSOURI BUCKET
Having your money in a taxable account is kind of like putting it in a bucket. The problem is every year the IRS punches a hole in your bucket and drains off some of that interest in taxes. However, placing your money in a savings bond or annuity is like adding a faucet to the bucket. The only time you pay taxes is when you decide to open the faucet and take out some of that interest.
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