Tax-deferred retirement plans give investors the opportunity to defer taxes on investment earnings until retirement (usually age 59½).
Pre-tax earnings can be reinvested, greatly compounding the amount of interest you earn from your investments. Some of the most common types of tax-deferred retirement plans include the following:
These plans give employees the ability to place a portion of their salary (up to $19,500 or 100% of their compensation for 2020) into a company-sponsored investment account. Taxes are deferred on earnings from the plan until they are withdrawn.
In addition, contributions to the plan are deducted from your ordinary income. Employees are given several options for investing the money into their 401ks. Most 401k plans have matching employer contributions.
Keogh plans are tax-deferred retirement plans for the self-employed and their employees. Contributions are deducted from ordinary income. The maximum annual contribution for 2020 is $57,000 or 100% of earned income, whichever is less.
In a Keogh plan, the self-employed individual controls which investments are bought and sold in the plan. Income earned from plan investments must be reinvested in the plan, and it grows tax-deferred.
Individual retirement accounts (IRAs)
Open to any gainfully employed person, IRAs are tax-deferred retirement plans that are directed by the employee. The maximum annual contribution for 2020 is $6,000 for an individual.
The non-working spouse of an IRA-eligible employee can also make a $6,000 contribution, if the couple's joint compensation is at least $12,000. IRA contributions may be fully or partially tax-deductible, depending on the taxpayer's (and/or spouse's) income and participation in an employer-sponsored, tax-favored retirement plan.
As with tax-qualified retirement plans, IRA investment earnings are tax-deferred until withdrawn at retirement. The amount of IRA contributions that may be deducted from personal income depends upon the taxpayer's income and whether the taxpayer (or spouse) is covered by an employee retirement plan at work.
Another strategy investors use to shelter themselves from taxes is tax swapping. A tax swap consists of two parts. First, the investor sells a security that incurred a capital loss.
Second, the investor buys a similar security, which the investor believes to be a better investment, to replace it. By swapping securities, the investor offsets his or her portfolio gains with a loss while leaving the portfolio essentially unchanged.
Repurchasing the same security within 30 days of its sale is called a wash sale and eliminates any tax deductions from the security's capital loss.
Tax planning can be very much worth the effort, but a word of caution is in order: the proper use of any strategy can be more complex than it appears. You may want to consult a tax advisor before implementing any specific investment strategies to discuss their tax implications.
Dive deeper: Tax shelters: What they are and how to use them
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