What Does Tax-Deferred Mean?
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. Interest, dividends, and capital gains are earnings that can be considered tax-deferred earnings.
Key Takeaways
- Tax-deferred status refers to investment earnings, such as interest, dividends, or capital gains, that accumulate tax-free until the investor takes constructive receipt of the profits.
- An investor benefits from the tax-free growth of earnings with tax-deferred investments
- The tax savings can be substantial when investments are held until retirement.
- A 401(k) plan is an example of a tax-deferred vehicle. It's a tax-qualified defined contribution account offered by employers to help grow their employees’ retirement savings.
Understanding Tax Deferral
An investor benefits from the tax-free growth of earnings with tax-deferred investments. The tax savings can be substantial for investments held until retirement when the retiree will likely be in a lower tax bracketand no longer be subject to premature tax and product withdrawal penalties.
Investing in qualified products such as IRAs allows participants to claim some or all of their contributions as a deduction on their tax returns. The benefit of declaring deductions in current years and incurring lower taxation in later years makes tax-deferred investments attractive.
Qualified Tax-Deferred Vehicles
A 401(k) plan is a tax-qualified defined contribution account offered by employers to help grow their employees’ retirement savings. Companies employ a third party administrator (TPA) to manage contributions, which are deducted from employee earnings.
Employees choose to invest these contributions among various options, such as equity funds, company stock, money market equivalents, or fixed-rate options. Contributions to qualified savings plans such as 401(k) accounts are made on a pre-tax basis. This reduces taxable income received by the employee in the year the contributions are made, which typically equates to lower tax liability.
Distributions from qualified plans are taxable as ordinary income if the owner is under the age of 59½ when they take the money. The IRS may assess a 10% premature withdrawal penalty in this case. Tax-deferral and employer dollar-matching provisions encourage employees to set aside wages for retirement savings.
Nonqualified Tax-Deferred Vehicles
Contributions to a nonqualified plan are made from post-tax income so they don't reduce taxable income in the year they're made. However, the earnings may accumulate tax-free if the plan is tax-deferred.
The contributions establish a cost basisfor interest calculations.
Many annuities and other nonqualified tax-deferred products don't restrict contribution amounts but individual retirement accounts such as traditional IRAs limit annual contributions:
- The traditional IRA contribution limit is $6,500 for 2023. Individuals who are 50 or older can invest an additional $1,000 as a catch-up contribution for a total of $7,500.
- The contribution limit increases to $7,000 in 2024. Individuals who are 50 or older can invest an additional $1,000 as a catch-up contribution for a total of $8,000.
Are Any Retirement Accounts Not Tax-Deferred?
Contributions made to designated Roth accounts are not tax-deferred. You pay taxes on this money in the year you earn it and you can't claim a tax deduction for these contributions. But Roth accounts aren't subject to required minimum distributions (RMDs) and you can take the money out in retirement, including its earnings, without paying taxes on it. Some rules apply.
What Is an Elective Deferral Limit?
An elective deferral is money that your employer contributes to your retirement plan. Your employer is effectively giving you this money but it's not included in your taxable income. The IRS therefore sets limits as to how much you can receive, usually toward 401(k), 403(b), SARSEP and/or SIMPLE IRA plans.
The 2023 elective deferral limit for these plans is $22,500. This increases to $23,000 in 2024. Anything in excess of these amounts is included in your taxable income for that year. The limit increases by $7,500 if you're age 50 or older.
What Is a Required Minimum Distribution?
A required minimum distribution (RMD) is the government's way of ensuring that it will eventually be paid taxes on your investments, and the IRS doesn't want to wait forever to collect its money. Federal law therefore imposes RMDs: ages by which you must begin taking money out of certain retirement accounts such as IRAs and 401(k)s and paying the taxes on the money that you didn't pay before.
You must begin taking RMDs by age 72 if you were born before Dec. 31, 2022. You have until age 73 if you reach age 72 after this date.
The Bottom Line
"Deferred" literally translates to "delayed." You'll pay taxes on this money eventually. Some individuals might prefer to pay those taxes in the current year in exchange for other perks such as those provided by Roth accounts. Others would rather pay taxes on the money at a later time in life when they'll presumably be in a lower tax bracket. Speak to an investment advisor or a tax professional if you have any questions about which option is best for you.
