A major advantage of tax-deferred investing is making contributions to a retirement account with pre-tax dollars. In many instances [e.g., 401(k) plans], the government allows taxable income to be reduced by the amount of the contribution to a tax-deferred retirement plan. As a result, you can have the same amount of money in your pocket and invest what you would have paid the government. For instance, if you are in the 28% marginal income tax bracket and you contribute $1,000 to a tax-deferred retirement plan, you would lower your federal income taxes by $280 (0.28 times $1,000). The savings is based on your marginal tax rate, i.e., the rate you pay on the highest dollar of earnings.

There were five different marginal tax rates in 2001, 15, 27.5, 30.5, 35.5, and 39.1%, which can change in the future. The higher your marginal tax rate, the more you as an investor benefit from pre-tax dollar contributions and tax-deferred earnings.

A second advantage of tax-deferred investing is that earnings grow faster because they aren. t taxed until withdrawn. Instead of paying tax on the interest earned, it continues to compound until the investment is sold. Over time, the gap between the value of a taxable and a tax-deferred account, earning the same rate of interest, increases sharply.

Penalties for Early Withdrawal

All tax-deferred accounts carry a penalty for withdrawing the money before age 59½. However, some types of accounts have exceptions, such as money withdrawn to be used to buy a first home, or if the owner of the account becomes disabled or dies. In addition, for some accounts, the penalty may not apply if the individual is taking equal periodic payments over his or her life expectancy for at least five years or until age 59½, whichever comes later, or for college expenses, and certain medical expenses. The penalty is usually 10% of the amount withdrawn and then, of course, federal and state income taxes also have to be paid on the withdrawal.

Types of Retirement Plans

The government allows several different types of tax-deferred retirement programs. Among these are employer-sponsored plans, plans for self-employed persons, and individual retirement accounts (IRAs). Many of the plans are named for sections of the tax code that establish these plans, [e.g., 401(k) and 403(b)]. These plans differ in who is eligible to participate, administrative responsibilities, allowable contribution limits, the types of investments available in the plan, and tax consequences and penalties for early withdrawal.

Employer-Sponsored Retirement Plans

Salary-reduction plans allow employees to deposit, through payroll deduction, part of their salary into a retirement account. There are a number of ways you, as an employee, can invest on a tax-deferred basis so that your investment will grow free of taxes and will not be taxed until you start making withdrawals.