Tax Savings or Tax Deferral, Which is Better?

Tax savings means that you pay a reduced amount of taxes, either because a particular type of investment income is taxed at a low rate or not at all, or because only a portion of the investment income is taxable. Most municipal bonds produce tax savings for their owners because their interest is not subject to federal income tax and may also be exempt from state and local taxes. Likewise, real estate investments can produce substantial tax-deductible expenses (such as mortgage interest, depreciation, and maintenance) that offset income and ultimately result in tax savings. Many other investments offer the opportunity to earn capital gains which can be subject to special low tax rates.

Tax deferral, on the other hand, refers to the postponement of payment of taxes, not an outright reduction or elimination of them. Because tax rates could be higher in the future, and due to the possibility of having more income to report, tax deferral could very well end up costing you more in taxes. The higher tax rates could result from changes in the Tax Code or the fact that your greater taxable income might push you up into a higher tax bracket. On the other hand, your effective tax rate could also be lower at the time the deferred income becomes taxable.

Deferring taxes has the advantage of letting you reinvest and earn more income on funds that would normally be lost to taxes. Deferring $1,000 of taxes allows you to put that money to work earning additional income until the tax must be paid. You’ll eventually be required to pay all of the deferred tax, but only after you’ve had the use of those funds that would otherwise have been in the hands of the taxing agencies.

The bottom line to tax deferral is that the value of your investment accumulates more rapidly because a greater amount of your interest earned remains available to be compounded. Assuming similar tax rates at the respective times of tax payment, deferral of taxes will always yield a greater overall return than paying the taxes on your investment currently. However, as stated previously, deferral means postponement of taxes, not that they will actually be saved. So, let’s assume that instead of having to pay those taxes at the end of the deferral period, that same investment was actually tax-free. When you withdrew the money you owed no taxes on it. Logically, this would be a better investment. You have the advantages of deferral so that more of your money is working for you to grow more quickly, plus the bonus of not having a tax bill to pay on that growth when you receive those funds.

Most investors are so eager to earn tax-free income that they will accept a significantly lower before-tax rate of return compared to what’s available from a taxable investment. This is because the taxes that would be due on the investment after the deferral period in many cases would lower the investment’s after-tax rate of return to an amount which is below that of the non-taxable investment.