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When it comes to investing, it’s critical to consider how taxes might impact your earnings. Luckily, some tax-efficient investment strategies allow your money to grow and compound without the immediate drag of taxes.
Some of the best retirement plans, including traditional IRAs and traditional 401(k)s, are tax-deferred. These accounts are considered an ideal place to park long-term investments, since you can escape paying taxes on realized gains for decades.
Here are key tax-deferred accounts available and how you can start investing in them.
Tax-deferred: What does it mean?
Since the introduction of the Individual Retirement Account (IRA) in 1974, the U.S. government has passed legislation letting individuals contribute to tax-advantaged accounts. These accounts motivate people to save for their retirement, so they aren’t solely reliant on government-funded programs such as Social Security.
In essence, contributions to tax-deferred accounts such as a traditional IRA or traditional 401(k) allow you to postpone paying taxes until you begin making withdrawals. At that point, the government taxes your earnings as ordinary income.
Tax-deferred accounts have two main advantages over typical taxable accounts:
First, they lower your annual taxable income when you contribute to them. When you add money to a tax-deferred account such as a traditional 401(k), it may come out of pre-tax income, reducing your taxable income for the year.
Second, you won’t owe taxes on your investment gains until you begin withdrawing the funds. If you realized a capital gain in a taxable account, you’d owe tax on it. And if you receive a dividend, then that’s taxable, too. (But there are other benefits, too.)
That’s why most financial professionals encourage investors to max out their contributions to tax-deferred accounts, especially if you are in a high tax bracket and expect to pay lower taxes in the future.
Types of tax-deferred investment accounts
Several types of investment accounts offer tax-deferred benefits to holders, each with their own benefits and eligibility criteria. Here are a few examples:
Types of tax-deferred investment accounts
Traditional IRAs
Tax-advantaged retirement accounts where contributions may be tax-deductible, and growth is tax-deferred until withdrawal.
Retirement plans such as a 401(k) and 403(b)
These employer-sponsored savings accounts for retirement often offer an employer match on your contribution and tax advantages.
Fixed deferred annuities
These insurance-based contracts offer guaranteed interest rates for future retirement income.
Variable annuities
These annuities are tied to investments, offering potential growth but with market-related risks.
I Bonds or EE Bonds
These U.S. government savings bonds offer low risk, and owners may elect to have their tax deferred. Series I bonds also offer inflation protection.
Whole life insurance
This kind of permanent life insurance may offer a tax-free benefit for beneficiaries and a cash-saving component that the policyholder can access or borrow against.
Through tax-deferred accounts such as an IRA or a 401(k), you can invest in stocks, exchange-traded funds (ETFs), mutual funds, bonds, certificates of deposit (CDs) and other assets. With potentially high-return investments such as stocks and stock funds, you can defer tax on enormous gains for years.
But even taxable investment accounts offer the ability to defer a capital gain as long as you don’t realize the gain by selling the investment. In fact, in some cases if your taxable income is low enough you can avoid capital gains taxes altogether.
What are the drawbacks of investing in tax-deferred accounts?
To enjoy the benefits of a tax-deferred account, the account holder must abide by various rules and restrictions.
A few of these rules include:
Contribution caps: Each year, the IRS establishes limits on how much you can save in tax-deferred accounts. The maximum contribution to a 401(k) plan in 2024 is $23,000, while the limit for IRA contributions is $7,000. Those 50 and over can contribute an additional $7,500 each year to a 401(k) and an extra $1,000 to an IRA.
Penalties on early withdrawals: Taking money early from tax-deferred accounts comes at a cost. The IRS will hit you with a 10 percent penalty if you withdraw funds from your 401(k) plan or IRA before age 59½. You’ll also owe taxes on the amount withdrawn, since you didn’t pay taxes on the income when it went into your account. Although you may be able to take early withdrawals in some circ*mstances, it’s usually not a good idea to touch your savings in these accounts.
Required withdrawals: Even though your money has grown tax-free, you will have to pay taxes on it eventually. This is the case for retirement accounts like an IRA or 401(k), which have required minimum distributions (RMD) starting at the age of 73. Missing or skipping an RMD can result in significant tax penalties.
Consulting with an investment advisor or tax professional is important to ensure you’re making the best decision for your financial situation and goals.
Bottom line
While the terms and conditions for tax-deferred accounts can be complex, the benefits can be substantial. By strategically using these accounts, you can optimize your wealth-building potential, allowing your investments to compound over time. Working with an expert advisor can help you make the most of these accounts, and Bankrate’s financial advisor matching tool can connect you to qualified professionals in minutes.
Tax deferral refers to instances where a taxpayer can delay paying taxes to some future period. In theory, the net taxes paid should be the same. Taxes can sometimes be deferred indefinitely, or may be taxed at a lower rate in the future, particularly for deferral of income taxes.
means you don't pay taxes until you withdraw your funds, instead of paying them upfront when you make contributions. With tax-deferred accounts, your contributions are typically deductible now, and you'll only pay applicable taxes on the money you withdraw in retirement.
First, they lower your annual taxable income when you contribute to them. When you add money to a tax-deferred account such as a traditional 401(k), it may come out of pre-tax income, reducing your taxable income for the year. Second, you won't owe taxes on your investment gains until you begin withdrawing the funds.
Tax deferral, simply put, postpones the payment of taxes on asset growth until a later date — meaning 100% of the growth is compounded and won't be taxed until you withdraw the money, usually at age 59½ or later, depending on the type of account or contract.
What is a tax-deferred investment? With a tax-deferred investment, you pay federal income taxes when you withdraw money from your investment, instead of paying taxes up front. Any earnings your contributions produce while invested are also tax deferred.
The drawbacks of tax-deferred retirement plans are limited access to funds, minimal investment options, and additional taxation upon the death of of a contributor.
A deferred tax asset represents a financial benefit, while a deferred tax liability indicates a future tax obligation or payment due. For example, retirement savers with traditional 401(k) plans make contributions to their accounts using pre-tax income.
Deferred compensation has the potential to increase capital gains over time when offered as an investment account or a stock option. Rather than simply receiving the amount that was initially deferred, a 401(k) and other deferred compensation plans can increase in value before retirement.
Deferred tax refers to income taxes that are due in future periods based on differences between the financial reporting and tax bases of assets and liabilities. Understanding deferred tax is important for companies to accurately represent their financial position.
Tax-deferred status refers to investment earnings that accumulate tax-free until the investor takes constructive receipt of the profits. Some common examples of tax-deferred investments include individual retirement accounts (IRAs) and deferred annuities.
To make an educated choice between traditional and Roth deferrals, you want to consider your current tax situation and your anticipated situation in retirement. In general, you want to choose traditional deferrals if you expect your tax rate to decrease in retirement and Roth deferrals if you expect it to increase.
The amount you can defer (including pre-tax and Roth contributions) to all your plans (not including 457(b) plans) is $23,000 in 2024 ($22,500 in 2023; $20,500 in 2022; $19,500 in 2020 and 2021; $19,000 in 2021).
While taxes are deferred until the future, keep in mind: All withdrawals from tax-deferred accounts are taxed as ordinary income. You can't use the assets in tax-deferred accounts for tax-loss harvesting. The assets in tax-deferred accounts don't receive a step-up in cost basis at death.
The combination of Social Security benefits plus withdrawals from tax-deferred accounts can wreak havoc on your retirement. Your Social Security income will most likely be fully taxable if you have $1 million or more in tax-deferred accounts like a 401(k) or IRA and must take RMDs.
Tax deductions are powerful financial tools. Making the maximum contributions to your tax-deferred accounts effectively takes a chunk of money you would have paid to the government and lets you keep it now and pay it later. The higher your tax bracket, the more you will save.
Tax-deferred and tax-free are two different concepts. Something that is tax-deferred is something that must eventually have taxes paid on it. Something that is tax-free will not need any tax payments made. One of the biggest differences between IRA accounts is in their tax set up.
A deferred tax liability represents an obligation to pay taxes in the future. The obligation originates when a company or individual delays an event that would cause it to also recognize tax expenses in the current period.
Make annual salary deferrals up to $22,500 in 2023 ($20,500 in 2022, $19,500 in 2021 and in 2020; $19,000 in 2019), plus an additional $7,500 in 2023 ($6,500 in 2022, in 2021 and in 2020 and $6,000 in 2015 - 2019) if you're 50 or older either on a pre-tax basis or as designated Roth contributions.
Under current federal tax law, deferred annuities receive special tax treatment. Income tax on earnings left to grow and compound in non-qualified annuities is deferred, which means you aren't taxed on the interest your money earns while it stays in the annuity.
Introduction: My name is Nathanael Baumbach, I am a fantastic, nice, victorious, brave, healthy, cute, glorious person who loves writing and wants to share my knowledge and understanding with you.
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