What Is a Tax-Deferred Investment Account?
These savings accounts put time on your side
Tax-deferred savings involves using 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 paying taxes on this investment income until you withdraw from the tax-deferred savings account or cash in the investment.
Using tax-deferred investment accounts makes the most sense if your income puts you into a high tax bracket now and you think you will be in a lower tax bracket in the future when you start taking withdrawals. The idea is to put time on your side, allowing years of investment savings and income to compound, without having to pay tax on it.
Ways to Accumulate Tax-Deferred Savings
There are several ways to make tax-deferred savings add up:
- 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 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, offering a guaranteed rate, or variable, allowing you to choose from a variety of investments with different return scenarios.
- Accumulate money inside a whole life insurance policy, 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
Let's assume that you invest $1,000 in a tax-deferred savings account like a 401(k) plan or IRA account, or use a tax-deferred annuity. 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, your investment account will have a balance of $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.
The following year, the original $1,000 and the new $50 of interest are both earning more interest for you. Because of compound interest, if the account grows another 5%, you will now earn $52.50.
When you have accounts that allow you to defer taxes until retirement, withdrawals of gains on your investment before age 59 ½ are typically subject you to a 10% penalty tax. This penalty is in addition to ordinary income taxes. 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. For example, whole life insurance policies allow you to borrow money from your policy's cash value. When you borrow the funds, you'll have no taxes or penalties due. If you've invested in I-Bonds, you pay taxes when you cash in the bonds, and that can occur at any age. You'll pay no penalty if you cash them in before age 59 ½.
When to Pay Taxes
When 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
Inside of these accounts, you can own just about any investment you can think of, including mutual funds, stocks, bonds, certificates of deposit, fixed annuities, variable annuities, and more.
- 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) plans, 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 or made with pre-tax dollars.
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 made with after-tax dollars, so they aren't quite tax-deferred. They do, however, grow tax-free and can have tax-free withdrawals as long as you follow the Roth IRA withdrawal rules.
- 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: Accrued interest 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 make a withdrawal that includes gains accrued in your policy's cash value.
The Bottom Line
When constructing your investment portfolio for long-term planning, you can defer your taxes as long as possible and take advantage of years or decades of compounding by using a variety of tax-deferred investments.