Taming Taxing Terminology
If you were asked to identify some confusing financial terms, would tax-deferred,
tax-exempt and tax-deductible top the list? Taking control of these terms can have a
tremendous impact on your savings and investment performance.
Tax-deferred means you don't pay taxes on your earnings until
you receive the money. Deferred annuities and life insurance cash values are a few
examples. Assume at age 40, you place $10,000 into a nonqualified annuity earning six
percent compounded annually. Because earnings grow tax-deferred, you would accumulate
$42,919 by age 65. You would then pay taxes as you withdrew your money. Ideally, this
would occur at retirement when you could be in a lower tax bracket. By comparison, if you
placed $10,000 in a taxable vehicle (such as a CD) earning six percent, you would need to
report each year's earnings on your tax return. Assuming you're in a 28 percent tax
bracket, your total value at age 65 would be $28,786.
Tax-exempt investments, such as tax-exempt municipal bonds,
avoid federal income taxes on income from the investment (state income and alternative
minimum taxes may still apply). However, the capital gains and losses on these investments
may be subject to federal income taxes.
Tax-deductible means the investment can be deducted from your
federal income tax. For example, if you meet deductibility guidelines, you can deduct all
or part of an IRA contribution on your federal income tax return. Even IRA contributions
that aren't tax-deductible offer tax-deferred earnings.
Understanding these terms can help you unleash the potential of your savings and
investments.
