A tax-deferred account is a savings or investment account that doesn't require that you claim the money earned inside the account on your tax return every year. This holds true as long as the funds remain in the account. You defer paying taxes until you withdraw money from the account.
What Is a Tax-Deferred Investment Account?
This type of account lets you postpone paying tax on the money in it until the taxes may be lower. Using tax-deferred 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 money from the account.
The idea of a tax-deferred account is to allow years of savings and income to compound without paying tax on it yearly.
How Tax-Deferred Accounts Work
Let's assume you invest $1,000 in a tax-deferred savings account like a 401(k) plan, an IRA, or a tax-deferred annuity. If the account value grows 5% from the increased value of the investments or interest income, your account would have a balance of $1,050 at the end of the year.
With this type of account, you don't have to claim the $50 as investment income on your current year’s tax return. The $50 was earned inside of a tax-deferred account or annuity.
The original $1,000 and the new $50 of interest earn even more interest for you the next year. If the account grows 5% again in the next year, you'll receive $52.50 of tax-deferred earnings because of compound interest.
This money is meant to be used to live off when you retire, and that's why it can remain in the account tax-free. Taking money from these accounts before age 59½ will trigger a 10% penalty tax from the IRS. Some exceptions exist, but it will depend on what you use the money for.
The 10% penalty for taking money out of the account early is added to any other income taxes you'll pay. The IRS allows you to grow your funds tax-deferred as a way to help you to save for retirement. Taking money out early defeats the purpose, so you will pay extra if you remove the funds from your account before you retire.
Not all types of tax-deferred options have a penalty for taking money out early. Whole life insurance allows you to borrow money from your plan'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, but that can occur at any age. You'll pay no penalty if you cash them in before age 59½.
You'll pay taxes at your normal 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 accounts when you construct your portfolio for long-term planning.
Types of Tax-Deferred Accounts
You have a few options for tax-deferred accounts. You can own just about any investment inside these. Assets within these accounts might include mutual funds, stocks, or bonds. They could also have CDs and fixed or variable annuities. The accounts could 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
Retirement plans fall into a few groups, but the most common ones are IRAs and the 401(k), (403)(b), and the 457 plans. They all offer tax deferral, but there are some notable differences between them.
The money you put into a traditional IRA grows 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 people or heads of household and less than $10,000 for a married person filing a separate return.
For 2021, the money you put in a traditional IRA can't exceed $6,000 in one year. This goes up to $7,000 a year if you're age 50 or older, in 2021.
The money you put into a Roth IRA consists of after-tax dollars. This means these accounts aren't quite tax-deferred. Still, they do grow free of tax, and you can take money out without paying tax on it because tax was paid on that money. You must follow the Roth IRA withdrawal rules to qualify. You can't take out any money until at least five years have passed since you opened the account.
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 widow.
401(k) Plans, 403(b) Plans, and 457 Plans
These are job-sponsored retirement plans. The funds you put into them may be tax deductible or made with pre-tax dollars. A 403(b) is offered by nonprofit employers, and a 457 plan is provided to government workers.
Types of Annuities, Bonds, & Insurance
There are other ways to save for when you retire besides plans available through work. These are a few of the most common options.
Fixed Deferred Annuities
These are insurance contracts that allow you to earn 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 ways to invest your money with diverse return scenarios. Investment income earned inside a variable annuity is tax-deferred until you take money out of the account.
I Bonds or EE Bonds
Interest you earn in bonds is tax-deferred until you cash them in. 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 tax-free if it's used for school.
Whole Life Insurance
You don't pay tax on earned interest until you cash in a whole life insurance plan or 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 compound interest and deferred tax payments benefit you most if you expect your tax bracket to be lower in the future.
- There are different rules and limits for each of these accounts.
- Tax-deferred accounts include IRAs, 401(k)s, I bonds, and whole life plans.