Using Tax-Advantaged Accounts
Franklin Templeton Investments
One smart way to invest for retirement is to use accounts that let your money
grow without generating a tax bill each year. Several tax-advantaged retirement
plan accounts exist specifically for this purpose.
When investing, you don't want to hinder your money's ability to grow,
especially if you're trying to accumulate a nest egg large enough to last
throughout your retirement years.
Annual taxes incurred by your investment returns can slow your nest egg's
growth. Thankfully, there are special tax-advantaged retirement accounts that
allow your money to grow without triggering an annual tax bill.
What does "tax-advantaged" mean?
The tax advantages offered by retirement plan accounts typically fall into one
of two broad categories:
- Taxes are deferred until you withdraw money from the account. (Withdrawals may
consist of contributions and accumulated earnings.)
- The money in the account grows and can be withdrawn tax free in some cases,
provided certain requirements are met.
Either way, letting the money grow without annual tax liability means your nest
egg can potentially benefit more from the effects of compounding.
Why use tax-advantaged accounts?
In tax-advantaged retirement accounts, dividend and capital gain distributions
are reinvested without being taxed. With no annual tax bill to slow the
potential effects of compounding, an investment held in a tax-advantaged
retirement account is likely to grow larger over the long term than the same
investment held in a taxable account. This possibility is illustrated in the
hypothetical example below.
A Tax Advantage Could Mean a Bigger Nest Egg
Hypothetical taxable vs. tax-advantaged account after 25 years
Comparison assumes $3,000 annual investments made at the beginning of each year
in a taxable and a tax-advantaged account with an annual rate of return of 8%
after expenses for both accounts. The $75,000 does not reflect any immediate tax
savings through deferrals into a tax-advantaged account but reflects the total
amount invested. Principal and income do not vary. Actual results will vary.
Distributions are reinvested in both accounts, but distributions in the taxable
account are taxed as ordinary income at the end of each year, and the investor
is subject to a 25% federal income tax rate on ordinary income. Does not include
the impact of state and/or local taxes. Savings accumulated in certain
tax-advantaged investments are taxable as ordinary income at the time of
withdrawal. This example does not reflect taxes that may be due at the time of
withdrawal. Because a maximum 15% federal capital gains tax rate may apply to
income on certain investments, the actual federal tax applicable to a portion of
the investments in an investor's taxable portfolio may be different than the
federal tax rate that would be applicable to that investor's ordinary income.
For illustrative purposes only. Calculations do not represent or predict the
performance of any Franklin Templeton fund. Investment return and principal
value of an investment in a mutual fund will fluctuate with market conditions.
An investment in a mutual fund does not guarantee that you will have sufficient
funds to meet future retirement income needs.
Types of tax-advantaged retirement accounts
There are 2 main types of tax-advantaged retirement accounts: individual
retirement accounts (IRAs) and employer-sponsored retirement plans, such as a
401(k) plan.
Each account type has its own rules governing contribution limits and
eligibility requirements, and tax penalties may apply for withdrawals made prior
to reaching age 59-1/2.
Unique qualities of employer plans
Employer-sponsored plans such as 401(k) or 403(b) plans offer some unique
features such as loans and employer contributions.
Reducing your income tax. Pretax contributions to a 401(k) or 403(b) plan are
made through salary deferrals before the government deducts income taxes.
(Contributions to Traditional IRAs may be tax deductible, depending on your
adjusted gross income and whether you're covered by an employer-sponsored plan.)
The result is less taxable income and, consequently, lower current taxes.
Compare the tax owed by 2 people making $50,000 per year, when one participates
in his company's 401(k) plan.
Reduce Taxable Income by Participating in an Employer Plan
Participant owes $105 less per month than non-participant
and is saving for retirement at the same time.
Assumes a federal income tax bracket of 25% and does not reflect the impact of
state or local income taxes.
By investing with pre-tax dollars and lowering tax liability, the real cost of
retirement account contributions is reduced.
Tax Savings Lowers the Real Cost of Contributions
These numbers can be even more dramatic when state and/or local income taxes, if
any, are considered.
Matching contributions from employers. Another big plus for employer-sponsored
plans is that some companies make contributions to their employees' accounts.
Employees who don't participate in the plan typically miss out on contributions
from their employer.
The bottom line
The tax advantages offered by retirement accounts can make it easier to
accumulate a larger nest egg than using taxable accounts. If you're not already
using one of these accounts as part of your retirement strategy, talk to your
financial advisor about the options available to you.
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Franklin
Templeton Investments or other mutual fund companies, visit Fund
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