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Revision as of 20:35, 5 May 2013 by Assumer (talk | contribs) (Moved discussion to the discussion page, and removed the list of tax-deferred section.)
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Looking for opinions on adding this section to Principles of Tax-Efficient Fund Placement (Explanation for the estimated order). See the User_talk:Assumer/Sandbox page for more discussion.

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.