Benefits of Tax-Deferred Investing

The U.S. Government passed a series of laws over the last 20 years to encourage saving and investing for retirement. In 1974, Congress created Individual Retirement Accounts, or IRAs, allowing investors to deduct a set amount of their annual contributions from their Federal income tax return, and reduce their annual income tax payment.

Current regulations allow you to deduct up to $2,000 of your annual IRA contribution from your individual income tax return. You may only be able to deduct part of your annual contributions, or none at all, if you participate in an employer-sponsored retirement plan or if your modified adjusted gross income exceeds current limits. Contributions to Roth IRAs are not tax deductible.

Earnings within an IRA are also tax-deferred. As you earn money on the investments within your IRA, the taxes you owe on these earnings are deferred until you withdraw the money from your account. This allows you to keep more of the money you earn every year and put it to back to work in the financial markets.

The chart below illustrates the advantages of tax-deferred growth. By contributing to a tax-deferred account, the taxes you would pay in a taxable account would instead be reinvested in the investments of your choice.

Also, by deferring tax payments until withdrawals are made, you may also reduce your total tax liability because you may be in a lower tax bracket when you draw on your Individual Retirement Account.

Jane and John each contribute $1,250 annually to their retirement portfolios -- John in a tax-deferred IRA and Jane in a "non-qualified" taxable account. Both investors earn 5% annually on their investments, and are in the 28% income tax bracket.

Because John's IRA is tax-deferred, he keeps more of the money he earns and reinvests it back into his portfolio. Jane must pay the IRS 28% of her annual earnings in her taxable account, which reduces the amount she can reinvest and leaves her almost 1/4 less than John after 30 years.