What is a Tax-Deferred Investment Account?
Tax-deferred accounts put time on your side
Tax-deferred savings occurs when you use a specially designated account, or investment option, that does not require you to claim the investment income earned inside of the account every year on your tax return. Instead, you get to defer this investment income until you choose to take a withdrawal from the tax-deferred savings account or until you cash in the investment.
The idea is to put time on your side, allowing years of investment income to compound, without having to pay tax on it.
You can accumulate tax-deferred savings in several ways:
- Fund tax-deferred accounts like an IRA or employer-sponsored retirement plan (such as a 401(k), 457 or 403(b) plan). Inside these accounts, you can purchase various different types of investments.
- Put money in a tax-deferred annuity which is an insurance contract that allows you to accumulate tax-deferred savings. Tax-deferred annuities can be fixed, which offer a guaranteed rate, or variable, where it allows you to choose from a variety of investments.
- Accumulate money inside a whole life insurance policy, or fund Roth IRAs, Health Savings Accounts, or by using certain types of government bonds such as Series EE Bonds or I-Bonds.
Example of How Tax-Deferral Works
- You invest $1,000 in a tax-deferred savings account (like a 401(k) plan, or IRA account), or use a tax-deferred annuity.
- It earns 5% in investment income.
- At the end of the year, the investment is worth $1,050.
- You do not have to claim the $50 as investment income on your current year’s tax return since it was earned inside of a tax-deferred account or tax-deferred annuity.
- Next year, the original $1,000 and the $50 of interest are both earning more interest for you.
When you use accounts that allow you to defer taxes until later, withdrawals of investment gain prior to age 59 ½ are usually subject to a 10% penalty tax. This penalty is in addition to ordinary income taxes. Think of it like this: the IRS allows you to grow your funds tax-deferred as an incentive to encourage you to save for retirement, but they penalize you if you use the funds too early.
Not all types of tax-deferred options have an early withdrawal penalty. For example, whole life insurance policies allow you to borrow money out. When you borrow the funds, there are no taxes or penalties due. With I-Bonds you pay taxes when you cash in the bonds, and that can occur at any age - there is no penalty if you cash them in before age 59 1/2.
When Do I Pay Taxes?
At the time that you take a withdrawal from a tax-deferred savings account, you will pay taxes at your ordinary income tax rate on any investment gain that is withdrawn. If your contributions to the account were also tax deductible, then you will pay taxes on the full amount of your withdrawal, not just the investment gain portion.
Types of Tax-Deferred Accounts
Below is a list of the types of accounts that have a tax-deferred status.
Inside of these accounts, you can own just about any type of investment you can think of; mutual funds, stocks, bonds, certificates of deposit, fixed annuities, variable annuities, etc.
- Traditional IRAs - investments inside of a traditional IRA grow tax-deferred. Your contributions to a traditional IRA may also be tax deductible if you meet the IRA contribution limits and rules requirements.
- Retirement plans like 401(k) accounts, 403(b) plans and 457 plans - investments inside of employer-sponsored retirement plans usually grow tax-deferred until you take withdrawals. Contributions may also be tax-deductible.
When you change employers, you can avoid a taxable withdrawal by using an IRA rollover to move funds directly from your plan to an IRA account, or by moving the funds directly to a plan with your new employer.
- Roth IRAs - investments inside of a Roth IRA are even better than tax-deferred; they grow tax-free as long as you follow the Roth IRA withdrawal rules.
Other Options With Tax-Deferral
- Fixed deferred annuities - interest earned in a fixed annuity is tax-deferred until you take withdrawals.
- Variable annuities - investment income earned inside of a variable annuity is tax-deferred until you take withdrawals.
- I Bonds or EE Bonds - interest accrued is tax-deferred until you cash in the bonds.
- Whole life insurance - interest earned is tax-deferred until you cash in the insurance policy, or take a withdrawal that includes gains accrued in your cash value.