The Tax-Deferred Bucket: What You Should Know 

by | Nov 4, 2022 | Blog | 0 comments

The tax-deferred bucket is an investment account that allows you to defer paying taxes on the money you contribute. This means that you won’t have to pay taxes on the money until you withdraw it. Common tax-deferred accounts include 401(k)s, 403(b)s, 457s, and IRAs.

The majority of Americans have at least one tax-deferred account. According to the Investment Company Institute, as of 2017, there were over 120 million 401(k) accounts in the United States alone.

However, statistics from Census Bureau report that fewer than 14% of employers offer their workers a 401k tax-deferred bucket. In addition, a recent survey by Census researchers reports that workers prefer to join companies that offer 401k bucket retirement packages

Tax-deferred contributions & distributions

Contributions to tax-deferred accounts are typically made with pre-tax dollars, so you won’t have to pay taxes on the money until you withdraw it. So, for example, if you contribute $10,000 to your 401(k), you won’t have to pay taxes on that $10,000 until you retire and start withdrawing from your account.

Distributions from tax-deferred accounts are also taxed as ordinary income. So, if you withdraw $10,000 from your 401(k), you’ll have to pay taxes on that $10,000 as if it were regular income.

The benefits of a tax-deferred account

The most significant benefit of a tax-deferred account is that you can save money on taxes now and defer paying taxes until later. This can be a massive advantage if you think your tax bracket will be lower when you retire.

A good example;  if you’re in the 25% tax bracket and contribute $10,000 to your 401(k). Then, when you retire and start withdrawing from your account, you’ll only be taxed on the money you withdraw, not the entire $10,000. So, if you withdraw $5,000, you’ll only have to pay taxes on that $5,000, which will be taxed at your lower tax rate.

The downside of a tax-deferred account:

The downside of a tax-deferred account is that you may end up in a higher tax bracket when you retire. This is because your income will be taxed as ordinary income, which means it will be taxed at a higher rate than capital gains.

For example, let’s say you’re in the 25% tax bracket and contribute $10,000 to your 401(k). When you retire and start withdrawing from your account, you’ll be taxed on the amount you withdraw, not just the $5,000 you withdrew. So, if you withdraw $10,000, you’ll have to pay taxes on that $10,000 as if it were regular income.

A math formula that could sink your IRA or your 401k

The biggest downside of a tax-deferred account is the risk of paying higher taxes later. This is because, as we mentioned earlier, distributions from tax-deferred accounts are taxed as ordinary income.

To calculate the risk of paying higher taxes later, you need to know your marginal tax rate. The marginal tax rate is the percentage of income tax you pay on your last dollar of taxable income.

For example, let’s say you’re in the 25% tax bracket, and your marginal tax rate is 28%. If you withdraw $10,000 from your 401(k), you’ll have to pay taxes on that $10,000 as if it were regular income.

As you can see, the risk of paying higher taxes increases as your marginal tax rate increases.

How to Avoid Risks

The best way to avoid this risk is to structure your tax-deferred account so that you’re in a lower tax bracket when you retire. This can be done by contributing to a Roth IRA instead of a traditional IRA.

By contributing to a Roth IRA with after-tax dollars, you can avoid paying taxes on the money when you withdraw it. If you believe your tax bracket will be higher during retirement, this can work significantly in your favor.

The other way to avoid this risk is to plan your withdrawals carefully. Knowing your marginal tax rate means you can withdraw enough money from your account to be in a lower tax bracket when you retire.

Pitfalls to avoid with tax-deferred accounts

There are a few pitfalls you need to avoid with tax-deferred accounts.

  •   First, make sure you don’t withdraw your money too early. If you do, you’ll have to pay taxes on the money you withdrew, plus a 10% penalty.
  •   The second pitfall is ensuring you don’t let your account grow too large. If you do, you may be taxed at a higher rate when you retire.

The best way to avoid these pitfalls is to consult a financial advisor. They can help you plan your withdrawals and ensure your account doesn’t grow too large.

A tax-deferred account can be a great way to save for retirement. However, ensure you understand the risks and benefits before contributing. TetonPines Financial will help you plan and make the right financial decisions for your tax-deferred bucket. Contact us today