What Is a Tax-Deferred Savings Plan?
A tax-deferred savings plan is an investment account that allows a taxpayer to postpone paying income taxes on the money invested until it is withdrawn, generally after retirement. The best-known such plans are individual retirement accounts (IRAs) and 401(k) plans.
Key Takeaways
- The 401(k) and traditional IRA are two common types of tax-deferred savings plans.
- Money saved by the investor is not taxed as income until it is withdrawn, usually after retirement.
- Since the money saved is deducted from gross income, the investor gets an immediate break on income tax. (In a Roth version of either account, the taxes are paid immediately.)
Tax-deferred savings plans are qualified by the Internal Revenue Service (IRS) and allow the taxpayer to pay money into the plan and subtract that amount from their taxable gross income for that year. The taxes on the contribution and its investment returns will be due only when the money is withdrawn, generally after the taxpayer retires.
For IRAs, contributions to traditional IRAs are tax deductible, with some income limitations if the taxpayer or their spouse has a retirement plan at work. Contributions to Roth IRAs are not tax deductible when the money is paid in, and there are income limits on who may contribute to a Roth IRA.
The money held in both types of IRAs grows tax-free until it is withdrawn.
Benefits of Tax-Deferred Plans
The tax-deferred savings plan was approved by the federal government as a way to encourage Americans to save for retirement. An individual may contribute a portion of pretax earnings to an investment account.
There are several benefits to the individual:
- Each year’s taxable earned income is reduced by the amount contributed to the account. This lowers the federal taxes owed by the individual for that year.
- The money is invested in the individual’s choice of mutual funds or other types of investments, with a balance that grows steadily until retirement. The pre-tax money boosts the amount invested and its potential growth over time.
- After retiring, the individual draws from the fund for income.
Tax-Deferred 401(k) and IRA Plans
Many companies offer employees a 401(k) for tax-deferred retirement savings. There are similar vehicles, such as the 403(b) for public service employees and the 457 for government employees.
Some employers also match a portion of the employee’s contribution up to a certain level. (Up to 3% of the employee's salary is typical.)
The self-employed and virtually anyone else with earned income can open an IRA. These are available through banks and brokerages, with a wide range of investment options.
At age 73, holders of 401(k)s and traditional IRAs must take required minimum distributions (RMDs), which are generally taxable at individual income rates. (The age was revised upwards from age 72 as of Jan. 1, 2023.)
Other Tax-deferred Savings Options
In addition to 401(k) plans and IRAs, several other types of investment offer tax deferral:
- Tax-deferred annuities: A tax-deferred annuity, also known as a tax-sheltered annuity, is a long-term investment account designed to provide regular income payments after retirement, similar to a pension. This type of annuity is available through insurance companies. The investor pays into the annuity account over years to build a balance that will be paid out in installments after retirement. The contributions are not tax-deferred, but taxes on the earnings in the account are not due for payment until the payouts begin. Tax-deferred annuities can be fixed, offering a guaranteed rate of return, or variable, allowing the individual to choose from a variety of investments that may increase (or decrease) the payments received.
- Tax-deferred U.S. savings bonds: The Series EE Bond and the Series I Bond are U.S. savings bonds issued by the government. They are tax-deferred and have an additional tax benefit if used to pay educational expenses. Series EE Bonds pay interest for the duration of the bond’s life, which is usually 20 years. Series I Bonds pay interest for up to 30 years. The interest paid to the bondholder is not taxed until the bond reaches its expiration date or is redeemed. In addition, an education tax exclusion shields the interest payments from income taxes if they are used to pay for educational expenses.
- Canadian RRSPs: The Registered Retirement Savings Plan (RRSP) is an example of a tax-deferred savings plan for Canadian taxpayers. The RRSP shelters what normally would be taxable income earned within the account until the money is withdrawn. All profits—including interest, dividends, and capital gains—also are tax deferred until they are withdrawn.
The interest on some U.S. savings bonds is tax deferred and may be tax exempt if the money is used for some educational expenses.
Penalty-Free Early Withdrawals
If the withdrawal meets one of the following stipulations (among many others), it could be exempt from the early withdrawal penalty:
- The funds are used to buy or rebuild a first home.
- The account holder becomes disabled.
- A beneficiary receives the assets after the account holder’s death.
- The money is used for medical expenses that were not reimbursed.
- Assets are for college tuition, fees, and other higher education expenses.
What Is a Tax-Deferred Investment?
Tax-deferred investment is a wide category. Generally, it is any investment in which the principal or interest is not taxed immediately.
For example, a Series I U.S. Bond, designed to fund education expenses, accrues interest for 30 years. At that time, the investor cashes in the bond and pays income tax on the interest.
A traditional Individual Retirement Account or 401(k) plan is another type of tax-deferred investment. In this case, the investor pays in pre-taxed money regularly. The money accrues interest over time. The tax on both the money paid in and its earnings remains untaxed until the money is withdrawn.
What Is the Benefit of a Tax-Deferred Investment?
True, taxes are inevitable. However, each type of tax-deferred investment has its own benefits.
For example, a traditional IRA reduces your taxable income by the amount you pay into it each year. Moreover, that untaxed income can accrue larger returns than the smaller amount of post-tax money you might have paid in. If your retirement income is less than your working income was, the money you then withdraw will be taxed at a lower rate.
Generally, there's one benefit to any tax-deferred investment: The money does not get taxed until it is actually paid out. You don't owe taxes year after year on the money you've stowed away for the future.
Is a Tax-Deferred IRA Better Than a Roth IRA?
A tax-deferred IRA, often called a traditional IRA, is a bit easier on the pocketbook during your working years. You get an immediate tax break while saving money.
A Roth IRA reduces your immediate income a bit more, although it's still yours for the future.The great benefit is that your account is entirely tax-free when you need it.
As a rule of thumb, many financial advisers say that a tax-deferred IRA is a better choice for people who expect their income (and their taxes) to be lower after they retire. A Roth is a better choice for people who expect to be in a high tax bracket after retiring.
The Bottom Line
A tax-deferred savings plan allows you to put off taxes on your invested money until you need it in retirement. Many vehicles to accomplish this are well-known, but if you have questions, check with a financial planner or tax expert.
