A tax-deferred account is a specially designated savings account or investment option that doesn't require that you claim the investment income earned inside the account on your tax return every year, as long as the funds remain in the account. You defer paying taxes until you withdraw from tax-deferred savings or cash in the investment.
What Is a Tax-Deferred Investment Account?
This type of account lets you postpone taxation until the bite isn't as severe. Using tax-deferred investment accounts makes sense if your income puts you into a high tax bracket now, and you think you'll be in a lower tax bracket in the future when you start taking withdrawals.
The idea is to put time on your side and allow years of investment savings and income to compound without paying tax on it annually.
How Tax-Deferred Savings and Investments Work
Let's assume you invest $1,000 in a tax-deferred savings account like a 401(k) plan or an IRA, or you use a tax-deferred annuity. Your investment account would have a balance of $1,050 if the account value grows 5% from the appreciating value of the investments or interest income, or a combination of both, at the end of the year,
You don't have to claim the $50 as investment income on your current year’s tax return because it was earned inside of a tax-deferred account or tax-deferred annuity.
The original $1,000 and the new $50 of interest are earning more interest for you the following year. If the account grows another 5% in the next year, you'll receive an additional $52.50 of tax-deferred earnings because of compound interest.
Withdrawals before age 59½ from an investment account that allows you to defer taxes until retirement will typically subject you to a 10% penalty tax, but some exceptions exist depending on what you use the money for.
This penalty is in addition to ordinary income taxes you'll pay. The IRS allows you to grow your funds tax-deferred as an incentive to encourage you to save for retirement, so they penalize you if you want to use the funds before you retire.
Not all types of tax-deferred options have an early withdrawal penalty, however. Whole life insurance policies allow you to borrow money from your policy's cash value with no taxes or penalties due. You'll pay taxes when you cash in the bonds if you've invested in I bonds, and that can occur at any age. But you'll pay no penalty if you cash them in before age 59½.
You'll pay taxes at your ordinary income tax rate on any investment gain that's withdrawn when you take money from a tax-deferred savings account.
You'd pay taxes on the full amount of your withdrawal, not just the investment gain portion if your contributions to the account were also tax-deductible. You can defer your taxes as long as possible and take advantage of years or decades of compounding by using various tax-deferred investments when you construct your investment portfolio for long-term planning.
Types of Tax-Deferred Accounts
You have multiple options for tax-deferred accounts, and you can own just about any investment inside these. Assets within these accounts might include mutual funds, stocks, or bonds. They could also have certificates of deposit, fixed annuities or variable annuities. The accounts generally include:
- Traditional IRAs
- Retirement plans like 401(k) plans, 403(b) plans, and 457 plans
- Roth IRAs
- Fixed deferred annuities
- Variable annuities
- I Bonds or EE Bonds
- Whole life insurance
Types of IRAs & 4XX Plans
Investments inside a traditional IRA grow tax-deferred. Your contributions can also be tax-deductible if you meet the IRA contribution limits and rules requirements.
- As of 2021, if a retirement plan at work covers you, your deduction for contributions will begin to phase out if your modified adjusted gross income (MAGI) is more than $105,000 but less than $125,000 for a married couple.
- This drops to more than $66,000 but less than $76,000 for single individuals or heads of household and less than $10,000 for a married individual filing a separate return.
Your total contributions to all traditional and Roth IRAs can't exceed $6,000, or $7,000 if you're age 50 or older, in 2021. These are the same limits that were in place in tax year 2020.
Investments inside a Roth IRA are made with after-tax dollars, so they aren't quite tax-deferred. However, they do grow tax-free and can have tax-free withdrawals as long as you follow the Roth IRA withdrawal rules. You can't take out any money until at least five years have passed since the account was established.
Earnings limits in 2021 for a Roth IRA range from $139,000 for a single person or head of household to $206,000 for a married couple or widower.
401(k) Plans, 403(b) Plans, and 457 Plans
These are employer-sponsored retirement plans where contributions may be tax-deductible or made with pre-tax dollars. A 403(b) is offered by non-profit corporations, and a 457 plan is provided to government employees.
Types of Annuities, Bonds, & Insurance
Fixed Deferred Annuities
This is an insurance contract that allows you to accumulate tax-deferred savings. A fixed annuity offers a guaranteed rate, making it popular with risk-averse people.
A variable annuity is an insurance contract with a variable interest rate, as the name suggests. It allows you to choose from a variety of investments with different return scenarios. Investment income earned inside a variable annuity is tax-deferred until you take withdrawals.
I Bonds or EE Bonds
Accrued interest is tax-deferred until you cash in the bonds. Series I bonds pay interest for 30 years and keep up with inflation. Series EE bonds pay interest for 30 years or until you cash them, whichever comes first. Interest on either can be non-taxable if it's used for education.
Whole Life Insurance
Earned Interest is tax-deferred until you cash in a whole life insurance policy or until you make a withdrawal that includes gains accrued in your policy's cash value.
- Tax-deferred accounts let you defer paying taxes on investment earnings until the money is withdrawn.
- This compounded interest and deferred tax payment benefit you most if you expect your tax bracket to be lower in the future.
- Different types of accounts have different rules and limits.
- Tax-deferred investments include IRAs, 401(k)s, I bonds and whole life insurance.