Besides helping you build income for your retirement, retirement plans may offer the added benefit of reducing the effects of taxes.
Many offer potential to build tax-deferred value, and some allow you to reduce your taxes on current income as well, by offering tax deductible contributions.
What is tax deferral?
"Tax-deferred" means that any earnings that build up in your plan are not taxed currently, as in other kinds of investments. Your earnings are free from taxation while they are in the plan. Once you draw them out, either at retirement or before, your earnings from these plans may be subject to taxes.
Even though you may have to pay taxes on your retirement plan earnings when you take them out, you may still pay less than if you had that income taxed as it was being earned. This is because you may have lower income in retirement, which may place you in a lower tax bracket.
You can contribute on a pre-tax basis
In addition to savings from tax deferral, some employer-sponsored plans allow you to contribute your income pre-tax, so you don't have to pay taxes on the money you contribute today (at least, not until you take the money out). With some non-employer-sponsored plans, your contributions can be taken as deductions from your income for tax purposes.
There is a price to be paid for all this tax freedom, however.
With most plans, any money you take out prior to retirement (age 59½ for IRA plans, age 55 with separation of service for most employer plans) can be subject to a 10% federal tax penalty in addition to being taxed. There are also limitations to how much you can contribute to some plans, based on your income or employment status.
This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.
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