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Revision as of 20:11, 5 May 2013 by LadyGeek (talk | contribs) (Changed example from non-deductible to Traditional IRA. Replied to several comments.)
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Looking for opinions on adding this section to Principles of Tax-Efficient Fund Placement (Explanation for the estimated order)

I now agree with LadyGeek and think we should put it in Tax_Basics.

I propose as a separate heading on the same level, and directly after, "Tax-advantaged accounts", perhaps titling it "Tax Deferment"?

I prefer "Advantages of tax deferment" as this is the intent of this section. If there were disadvantages, and both were discussed, I would agree. --LadyGeek 19:11, 5 May 2013 (CDT)


Advantages of tax deferment

Tax deferment is the process of paying the taxes you owe on an investment in a future year, instead of the current year. It may not be clear why deferring taxes is a good idea, especially if you expect to be in the same tax bracket in the future. For an example, refer to Table 1, in which the taxes you owe on an investment return are paid in year 5, compared to annually.

This example compares a hypothetical investment of $10,000 in a taxable vehicle (such as a bond or CD) returning 6% annually for 5 years. The investor is assumed to be in the 25% tax bracket both during the investment and the withdrawal stage. A tax-deferred account (such as a Traditional IRA) waits until the investor withdraws the funds, and then taxes are paid on the entire, cumulative, amount of gains. In a taxable account, the 25% tax is paid each year on the gains for that given year.

Start with $10,000. After year 1, you will have $150 less total return after taxes (compared to the non-taxed amount of $10,600). Going into year 5, you will be starting with a higher amount ($12,625) if the taxes were deferred than not ($11,925). In year 5 (the year where the taxes have been deferred to) you will end up with a higher starting amount, which shows that deferring taxes is the best approach. In both cases, you pay the tax (25%) on the total return (25% * $3,282 = $821, 25% * $3,382 = $846) but in the tax-deferred example, you were able to accumulate more of a return before taxes had to be paid.

Table 1. Tax Deferment
Year Return   Taxable   Tax-Deferred
Tax Rate Return Taxes Total Tax Rate Return Taxes Total
0 - - - - $10,000 - - - $10,000
1 6% 25% $600 $150 $10,450 - $600 - $10,600
2 6% 25% $627 $157 $10,920 - $636 - $11,236
3 6% 25% $655 $164 $11,412 - $674 - $11,910
4 6% 25% $685 $171 $11,925 - $715 - $12,625
5 6% 25% $716 $179 $12,462 25% (of total return) $757 $846 $12,537
Total 25% $3,283 $821 $12,462 25% $3,382 $846 $12,537

It can be seen that deferring the taxes yields a final, after-tax amount of $12,537 for this hypothetical investor, while paying taxes each years yields a final, after-tax amount of $12,462. Having a tax-deferred account has returned $75 more than a taxable account.

List of Tax-Deferred Accounts

Do we want this section?

  • Traditional IRA
  • I-Bonds
  • 529

No, there are too many complexities. For example, I Bonds are taxable at the federal level, but not state level - unless it's used for education. For the wiki, it's best not to give explicit tax guidance as giving the wrong advice is worse than none at all.--LadyGeek 19:11, 5 May 2013 (CDT)

Editor's note: Did I do these calculations correctly? --Assumer 08:14, 26 March 2013 (CDT)

How do I put more of a "break" between the taxable and tax deferred columns? Like a double vertical bar? --Assumer 08:14, 26 March 2013 (CDT)

You can get a lot more complicated as shown here: wikipedia:Help:Table#Setting borders, but one simple approach is to insert a non-break space (&nbsp;) see wikipedia:List of XML and HTML character entity references. Tables usually ignore spaces, but non-break spaces force the insertion. Note the column spans the table. --LadyGeek 21:12, 26 March 2013 (CDT)

How do I add a break before the final