I am a 52 year old widow and my husband passed away eight years ago. He put a lot of our retirement money in bank CDs because he said they were safe, and this year they are all coming to maturity. I’m trying to decide whether I should renew them or not. I keep hearing about tax-deferred growth and I’m wondering if there might be a better investment for me. I want to keep my money safe, but I don’t want to be stupid about it. Can you please explain to me in real simple terms what a tax-deferred investment is and why I would want one?
I applaud you on taking charge of your finances by educating yourself. Yes, there are other investments that can keep your retirement money safe and give you tax-deferred growth. In simple terms, there are three ways you can pay taxes on an investment:
Ideally, you want your retirement portfolio to be made up of all three kinds of taxable investments so you aren’t saddled with your tax burdens all at once. (Yes, it would be nice if we could have tax-free investments all the time, but that’s just not realistic.)
Investments are named according to how they are taxed in this way:
- Taxable: you will be taxed now
- Tax-Deferred: you will be taxed later
- Tax-Free: you won’t be taxed at all.
Tax-deferred investments benefit from a phenomenon known as triple compounding. What this means is that more of your money is used to calculate the interest earned because you don’t have to take it out of the investment to pay taxes.
Imagine a $1 investment allowed to grow over a 20-year time period by doubling annually.
In bucket A we have a taxable investment such as your bank CDs where you pay annual taxes at a rate of 28 percent on the interest earned:
In bucket B we have a tax-deferred investment such as an annuity where the earnings are allowed to grow tax-deferred:
Taxable vs Tax-Deferred
Value of Bucket A: Taxable: $51,353.00
Value of Bucket B: Tax Deferred: $1,048,567.00
In your situation, you could safely grow more money in a tax-deferred investment such as an annuity than with a taxable investment such as a bank CD. Keep in mind here that we are only talking about safe investments, where your principal amount is guaranteed.
When deciding which investments are best, there are other considerations such as your age, timeline and individual retirement goals. Make sure you understand the investment in terms of both the pros and the cons before you purchase.
Bottom Line: A tax-deferred investment allows you to grow more money due to something known as triple compounding.
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