Tax-deferred investing is a gift from Uncle Sam to you to help you save for your retirement. With tax-deferred investing, the government allows you to invest pre-tax money in certain retirement accounts—401(k)s and IRAs. The idea is that the more money you put into your retirement account up front, the more money you will make.
Of course, the government wants its taxes sometime. That's why it is called tax-deferred investing and not tax-free investing, but it's better than nothing.
Here's how it works. Imagine you have $10,000 you would like to invest. If you pay taxes on that money before you invest it, you will only be left with about $8,000 (give or take) to actually put into your account. However, if you don't pay taxes on that money before you invest it, you will have the full $10,000 to put into your acount. This is what your investing returns would look like after 10 years earning 10 percent per year.
Non Tax-Deferred (After Tax)
Tax-Deferred (Pre-Tax)
Principal
Interest $
Total Interest
Principal
Interest $
Total Interest
$8,000
$800
$800
$10,000
$1,000
$1,000
$8,800
$880
$1,680
$11,000
$1,100
$2,100
$9,680
$968
$2,648
$12,100
$1,210
$3,310
$10,648
$1,064
$3,712
$13,310
$1,331
$4,641
$11,712
$1,171
$4,883
$14,641
$1,464
$6,105
$12,883
$1,288
$6,171
$16,105
$1,611
$7,716
$14,171
$1,417
$7,588
$17,715
$1,772
$9,488
$15,588
$1,559
$9,147
$19,487
$1,949
$11,437
$17,147
$1,715
$10,863
$21,436
$2,144
$13,581
$18,862
$1,886
$12,749
$23,579
$2,358
$15,939
By not paying taxes on your money before you started investing it, you would have made 25 percent more ($15,939) in your account than you would have if you had paid taxes on your money before you invested it ($12,749). Plus, when you think about the time value of money, that difference gets wider and wider as time goes on.
Video: Tax-Deferred Investing
Now that you've got the basics of tax-deferred investing, check out the video below and see what else you can learn about tax-deferred investing at the whiteboard.
Taking Your Next Step
Once you're comfortable with tax-deferred investing, it's time to move on and learn about Diversification.
