What Is a Tax-Deferred Investment Account?
Definition & Examples of Tax-Deferred Investment Accounts
A tax-deferred account is a specially designated savings account or investment option that does not require you to claim the investment income earned inside the account every year on your tax return if the funds remain in the account.
What Is a Tax-Deferred Investment Account?
With a tax-deferred account, you defer paying taxes 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 and allow years of investment savings and income to compound without having to pay 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 IRA, 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% in the following year, you will receive an additional $52.50 of tax-deferred earnings.
When you have accounts that allow you to defer taxes until retirement, withdrawals of gains on your investment before age 59 ½ 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 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. 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.
Types of Tax-Deferred Accounts
There are multiple types of tax-deferred accounts and inside of these, you can own just about any investment—including mutual funds, stocks, bonds, certificates of deposit, fixed annuities, variable annuities, and more. The accounts 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
Investments inside a traditional IRA grow tax-deferred. Your contributions may also be tax-deductible if you meet the IRA contribution limits and rules requirements. If you are covered by a retirement plan at work, your deduction for contributions phases out if your modified adjusted gross income (AGI) is more than $104,000 but less than $124,000 for a married couple, more than $65,000 but less than $75,000 for a single individual or head of household, and less than $10,000 for a married individual filing a separate return.
For 2020, your total contributions to all traditional and Roth IRAs cannot exceed $6,000 ($7,000 if you are age 50 or older).
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 used by non-profit corporations and a 457 is for government employees.
Investments inside 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 and don't take out any money until at least five years after the account is established. Earnings limits in 2020 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.
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.
This is an insurance contract where the interest rate is variable, allowing 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 may be non-taxable if used for education.
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.
- Tax-deferred accounts let you defer paying taxes on investment earnings until the money is withdrawn.
- This compounded interest and deferred tax payment is of most benefit 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.
Internal Revenue Service. "Topic No. 588 Additional Tax on Early Distributions from Retirement Plans Other Than IRAs." Accessed July 19, 2020.
Internal Revenue Service. "Publication 590-A (2019), Contributions to Individual Retirement Arrangements (IRAs)." Accessed July 19, 2020.
Internal Revenue Service. "Retirement Topics - IRA Contribution Limits." Accessed July 19, 2020.
Internal Revenue Service. "Amount of Roth IRA Contributions That You Can Make in 2020." Accessed July 19, 2020.
TreasuryDirect. "Tax Considerations for I Bonds." Accessed July 19, 2020.
TreasuryDirect. "Series EE Bonds." Accessed July 19, 2020.