Tax deferred

What Is Tax-Deferred?

Tax-deferred refers to investment earnings on which applicable taxes are not paid until a future date, typically when the money is withdrawn during retirement. This is a crucial concept within personal finance and tax planning, allowing investments to grow more significantly over time as gains are reinvested without immediate tax erosion. The principal amount contributed may or may not be tax-deductible in the current year, depending on the specific account type. Common tax-deferred accounts include traditional Individual Retirement Accounts (IRAs), 401(k)s, and annuities.

History and Origin

The concept of encouraging long-term savings through tax incentives has roots in various legislative acts designed to promote financial security for Americans. A significant milestone in the history of tax-deferred savings was the Employee Retirement Income Security Act of 1974 (ERISA). This federal law set minimum standards for most voluntarily established retirement and health plans in private industry, providing protections for individuals in these plans.¹⁹, ²⁰ ERISA's introduction aimed to protect employees' retirement savings and ensure proper management of benefit plans. The subsequent creation and expansion of specific tax-deferred vehicles, such as the 401(k) in 1978, further solidified the role of tax deferral in retirement planning, allowing for growth free from annual taxation.

Key Takeaways

• Tax-deferred investments allow earnings to grow without being subject to annual taxation.
• Taxes on gains and sometimes contributions are paid at a later date, often during retirement.
• Common tax-deferred accounts include traditional IRAs, 401(k)s, and variable annuities.
• The benefit of tax deferral is maximized over long investment horizons due to the power of compounding.
• Withdrawals from tax-deferred accounts in retirement are typically taxed as ordinary income.

Interpreting the Tax-Deferred

Interpreting the benefit of tax deferral involves understanding its impact on the long-term growth of an investment. The primary advantage lies in the ability for earnings to compound on a larger base, as taxes are not siphoned off annually. This allows for greater capital accumulation compared to a taxable account, where investment gains are taxed each year.

For example, consider two identical investments, one in a tax-deferred account and one in a taxable account. If both earn 8% annually, the taxable account might only see 6% net growth after accounting for capital gains tax, while the tax-deferred account retains the full 8% growth. Over decades, this difference in annual growth rates leads to substantially different ending balances due to the effect of compound interest. Investors should also consider their expected tax bracket in retirement versus their current tax bracket when evaluating the overall benefit of tax-deferred savings.

Hypothetical Example

Imagine Sarah, aged 30, invests $5,000 annually into a tax-deferred 401(k) account, earning an average annual return of 7%. Her friend, John, also aged 30, invests the same $5,000 annually into a taxable brokerage account, also earning 7% before taxes. Assume John pays a 20% capital gains tax rate on his earnings each year.

For Sarah, her entire 7% annual return is reinvested. For John, his effective annual return after tax is (7% \times (1 - 0.20) = 5.6%).

After 35 years, when both reach age 65:

• Sarah's Tax-Deferred 401(k): The future value of her annual contributions, compounded at 7% for 35 years, would be approximately $799,000.
• John's Taxable Account: The future value of his annual contributions, compounded at 5.6% (net of taxes) for 35 years, would be approximately $508,000.

This hypothetical example illustrates how the tax-deferred growth allows Sarah's investment to accumulate significantly more capital over the long term, even before considering the taxes she will eventually pay upon withdrawal in retirement. The power of compounding is amplified in a tax-deferred environment.

Practical Applications

Tax deferral is a cornerstone of many financial planning strategies, particularly for retirement savings. Its primary application is in various retirement accounts designed to encourage long-term wealth accumulation.

• Employer-Sponsored Retirement Plans: Plans like 401(k)s, 403(b)s, and 457(b)s allow employees to contribute pre-tax dollars, and both contributions and earnings grow tax-deferred until withdrawal. The Internal Revenue Service (IRS) provides detailed information on these and other retirement plans.¹⁷, ¹⁸
• Individual Retirement Accounts (IRAs): Traditional IRAs offer tax-deductible contributions (for many) and tax-deferred growth.¹⁶
• Annuities: These are contracts with insurance companies that can offer tax-deferred growth on investments. Both variable annuities and indexed annuities can offer tax deferral on investment gains, with taxes typically due upon withdrawal.¹³, ¹⁴, ¹⁵ The Securities and Exchange Commission (SEC) regulates some annuities, highlighting their features and risks.¹¹, ¹²
• Education Savings Accounts: Certain education savings vehicles, like 529 plans, also offer tax-deferred growth, with qualified withdrawals being tax-free.

These vehicles allow investors to defer paying taxes on investment gains, which can lead to a larger sum of money available at retirement or for specific qualified expenses.

Limitations and Criticisms

While advantageous for long-term growth, tax deferral has certain limitations and criticisms. A primary consideration is that while taxes are deferred, they are not eliminated. Withdrawals from many tax-deferred accounts in retirement are typically taxed as ordinary income, which could be at a higher rate than long-term capital gains if the assets were held in a taxable account. The IRS may also impose penalties for withdrawals made before a certain age, usually 59½, with some exceptions.
¹⁰
Another limitation involves required minimum distributions (RMDs), which mandate that account holders begin withdrawing money from most tax-deferred retirement accounts once they reach a certain age (currently 73), whether they need the money or not. ⁹This can force individuals into higher income tax brackets in retirement than anticipated.

Critics also point out that the benefit of tax deferral heavily depends on an individual's tax bracket in retirement compared to their working years. If an investor's tax bracket is higher in retirement, the deferred tax might ultimately be more expensive than if the taxes were paid annually at a lower rate. Additionally, the fees associated with some tax-deferred products, such as annuities, can sometimes erode the benefits of deferral. ⁸The Bogleheads community often discusses the importance of tax efficiency and the optimal placement of assets across different account types to minimize the overall tax burden.
⁶, ⁷

Tax-Deferred vs. Tax-Exempt

The terms "tax-deferred" and "tax-exempt" are often confused, but they represent distinct tax treatments. Tax-deferred means that taxes on investment earnings are postponed until a later date, typically at withdrawal. Contributions to these accounts may be tax-deductible, but withdrawals in retirement are taxed as ordinary income. Examples include traditional 401(k)s and IRAs.

In contrast, tax-exempt refers to investments or income that are entirely free from certain taxes. For instance, municipal bonds can offer interest income that is exempt from federal income tax and sometimes state and local taxes, depending on where the bond is issued and the investor resides. Another prominent example is a Roth IRA. Contributions to a Roth IRA are made with after-tax dollars, meaning they are not tax-deductible. However, qualified withdrawals in retirement, including both contributions and earnings, are entirely tax-free. The key difference lies in when the tax benefit is realized: deferred means later, while exempt means never (for the specified tax).

FAQs

What types of investments typically offer tax deferral?

Many retirement savings vehicles offer tax deferral, including traditional 401(k) plans, 403(b) plans, 457(b) plans, traditional Individual Retirement Accounts (IRAs), and annuities. Some education savings plans, such as 529 plans, also provide tax-deferred growth.
⁴, ⁵

When do I pay taxes on a tax-deferred account?

You generally pay taxes on the earnings and, in some cases, the principal (if contributions were tax-deductible), when you withdraw money from the account. This usually occurs during retirement. If withdrawals are made before age 59½, they may be subject to a 10% penalty in addition to ordinary income tax.

³### Is tax deferral always beneficial?

Tax deferral is generally beneficial for long-term growth, especially due to the power of compounding returns. However, its overall advantage depends on your individual tax situation, particularly whether your tax bracket will be lower in retirement than during your working years. I²f your retirement tax rate is higher, the deferred tax could be more costly.

Can I transfer funds between tax-deferred accounts without triggering taxes?

Yes, direct rollovers or trustee-to-trustee transfers between similar types of tax-deferred accounts, such as a 401(k) to a traditional IRA, can typically be done without triggering immediate tax consequences. These are known as tax-free rollovers. However, converting a traditional IRA to a Roth IRA, for example, would involve paying taxes on the converted amount.

What is the difference between tax-deferred and tax-deductible?

Tax-deferred relates to the postponement of taxes on investment earnings. Tax-deductible refers to contributions that can be subtracted from your taxable income in the current year, reducing your immediate tax liability. Many tax-deferred accounts, like traditional 401(k)s and IRAs, also offer tax-deductible contributions. H¹owever, some accounts, such as non-qualified annuities, are tax-deferred but do not offer a tax deduction for contributions.