Are you a schoolteacher or are you employed by a non-profit organization? Funded by your own pre-tax contributions, a 403(b)(7) account—if available at your employer—can be an effective way to invest, save money and plan for your financial future.
How do they work?
You own and control your own 403(b)(7) accounts, and they enter into salary reduction agreements with their employer to make pre-tax payroll contributions to them. Contributions and account earnings are not taxed until withdrawal.
The 4 key benefits
1. Effective way to reduce current taxes while saving for retirement
2. No special eligibility rules for participation
3. Full and immediate vesting of all contributions
4. Tax-deferred compounding In a tax-deferred account, you will not pay taxes on your contributions or account earnings until you take withdrawals — which can make a significant difference over time.
Here is an example to illustrate…
Annual $10,000 payroll contributions are made to a tax-deferred account. Assuming 40 years of contributions, and a 7% hypothetical return, the tax-deferred account will have a pre-tax value of about $2.1 million at retirement, representing approximately $1.7 million in growth ($2,136,096 pre-tax value minus $400,000 investment amount). If the $10,000 is received as current taxable compensation and invested into a taxable account subject each year to a blended 22% federal tax rate, the account would accumulate about only $1.4 million over the same period, that is growth that just exceeds $1,000,000 ($1,426,442 taxable account value minus $400,000 investment amount).
The growth of the tax-deferred account beats the taxable account by over $700,000 due to the power of tax-deferred compounding. Please note that distributions from a tax-deferred account are taxed as ordinary income in the year made, and early withdrawal prior to age 59½ generally are also subject to a 10% additional federal tax. The impact of such taxes is not reflected in the above illustration.
Your actual experience will vary depending on your actual investment returns and your specific tax rate (which may be more or less than the figures shown). Capital gains and qualified dividends may receive more favorable tax treatment within a taxable account relative to a tax-deferred account due to the lower rates currently applicable to long-term capital gains and qualified dividends and the fact that all distributions from a tax-deferred account are taxed as ordinary income.
*The $400,000 investment amount was calculated by multiplying the annual $10,000 investment by 40 years. Please note that for the taxable account, in order to be able to invest $400,000 you will have had to earn a higher amount because your investment is made on an after-tax basis.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.