Is deferring tax a smart long-term decision? Do I have other options?
When it comes to deferring taxes, most individuals automatically assume that it is a smart idea.
“Paying taxes later, right? What could be bad about that?”
But the reality is that, just like any other financial decision you make, there is an upside and a downside.
And deferring taxes is no different. In some cases it can work well. However, in more cases than you would probably assume, deferring taxes actually ends up being more harmful than helpful.
The alternative to deferring taxes is to pay the tax now, before investing money. Now, if the investment you put your money is charges you a tax, then deferring taxes will probably, in almost all cases, be a better option.
However, with Infinite Banking, there are tax advantages that allow us to avoid taxation on our growth indefinitely. Thus, we pay tax now on our money, and we never have to pay taxes on the growth on that money if we follow the Infinite Banking strategy correctly.
Now, obviously the underlying investment that you use will make a significant difference. And government sponsored plans like a 401k or IRA will often be tax-deferred.
Getting a match on these investments can be hard to pass up. This makes the comparison to a 401k alternative like Infinite Banking difficult. Keep that in mind as we explore this topic.
Let’s look at deferring taxes, and the three situations where deferring taxes may actually be hurting you in the long run.
The first scenario where deferring taxes may hurt you is the tax rate itself.
This chart shows historical tax rates. Currently, we are currently in some of the lowest all around tax rates ever.
So, if tax rates go anywhere they are likely to go up. And, if they do, those who defer tax will most likely end up paying more in taxes than they would have had they just taken the money and paid taxes on it when it was earned.
This is the first scenario where deferring tax could end up hurting more than helping.
Earning More Money
Secondly, if we want to make deferring taxes worthwhile, we need to be in a similar, if not a lower, tax bracket when we take the money out than when we put the money in.
However, most of us want to, and will, end up making more money towards the end of our lives than at the beginning. If we are making more money, we are in a higher tax bracket.
Often the argument is that, during retirement, we will be in a lower tax bracket because we aren’t making money.
But less and less people are retiring early, if at all. And many are still making money from investments, real estate, etc. after retiring. Effectively making the deferred tax advantages obsolete, and often putting us in a worse situation than we would have been in had we just paid the taxes while we were younger.
Lastly is tax deductions. Family and child deductions, housing interest deductions, and other deductions are usually heavily loaded in our younger years. And, as we get older and more founded, these deductions fade away.
If we have less deductions when we take the money out than we would have had when we put the money in, we are effectively putting ourselves in a position to pay more in taxes than we would have when we put the money in. This is another case where we are losing by deferring tax for the future.
Understanding Your Options
Deferring taxes isn’t always bad. However, as we can see in these cases, there seem to be many scenarios where deferring taxes won’t do much good.
We have talked to several accountants and the consensus seems to be unanimous. Most people end up paying more taxes on their deferred investments than they would have had they just paid the taxes upfront.
Understanding this can give you the power to make the best decision for you.
Along with deferring taxes, 401ks and IRAs also lack liquidity–or access to your money–another very important factor to consider.
No matter what decision you make. Educate yourself and make your decisions based on the facts, don’t leave your financial future to chance.