What Does Tax-Deferred Mean?
Let me explain tax-deferred to you directly: it means your investment earnings build up without taxes hitting them until you actually pull the money out. You see this in things like individual retirement accounts (IRAs) and deferred annuities, where stuff like interest, dividends, and capital gains grow without the tax bite right away.
Key Takeaways
Here's what you need to grasp: tax-deferred status applies to earnings such as interest, dividends, or capital gains that pile up tax-free until you take possession of them. As an investor, you get the advantage of this tax-free growth. The savings on taxes can really add up if you hold these until retirement. Take a 401(k) plan—it's a prime example, a tax-qualified account from employers designed to boost your retirement nest egg.
Understanding Tax Deferral
I want you to understand how tax deferral works: it lets you enjoy tax-free growth on your earnings over the years. If you keep investments until retirement, the tax savings can be significant, especially since you'll probably be in a lower tax bracket then, and you avoid early withdrawal penalties.
When you put money into qualified options like IRAs, you can deduct some or all of those contributions on your tax return. That's appealing because you get the deduction now and pay lower taxes later.
Qualified Tax-Deferred Vehicles
Consider a 401(k) plan—it's a tax-qualified defined contribution account that employers offer to help you build retirement savings. They use a third-party administrator to handle the contributions, which come straight out of your paycheck.
You decide where to invest those contributions, maybe in equity funds, company stock, money market options, or fixed-rate choices. These contributions are pre-tax, so they cut your taxable income for that year, often lowering what you owe in taxes.
If you withdraw from these plans before age 59½, the distributions count as ordinary income and might trigger a 10% penalty from the IRS. Still, the tax deferral and any employer matching make it smart to sock away money for retirement.
Nonqualified Tax-Deferred Vehicles
With nonqualified plans, you make contributions from after-tax income, so they don't lower your taxable income that year. But the earnings can still grow tax-free if the plan is set up as tax-deferred.
Contributions create a cost basis for calculating interest. Many annuities and similar nonqualified products have no limits on how much you can contribute, unlike traditional IRAs, which cap annual contributions at $7,000 for 2024 and 2025, or $8,000 if you're 50 or older with the catch-up option.
Are Any Retirement Accounts Not Tax-Deferred?
Yes, contributions to Roth accounts aren't tax-deferred—you pay taxes on that money in the year you earn it, and you can't deduct them. However, Roths don't require minimum distributions, and you can withdraw the money, including earnings, tax-free in retirement, as long as you follow the rules.
What Is an Elective Deferral Limit?
An elective deferral is the money your employer puts into your retirement plan—it's like they're giving it to you, but it doesn't count in your taxable income. The IRS limits this for plans like 401(k), 403(b), SARSEP, and SIMPLE IRAs. For 2025, the limit is $23,500, and anything over that gets taxed. If you're 50 or older, you can add $7,500 more.
What Is a Required Minimum Distribution?
A required minimum distribution (RMD) is how the government makes sure it gets its taxes eventually—the IRS doesn't want to wait forever. Federal law requires you to start pulling money from accounts like IRAs and 401(k)s by certain ages and pay the deferred taxes. If you were born before December 31, 2022, you start at age 72; otherwise, it's age 73.
The Bottom Line
Deferred means delayed, so you'll pay taxes on this money sooner or later. Some people choose to pay now for benefits like those in Roth accounts. Others prefer delaying to a time when they're in a lower tax bracket. If you're unsure which is right for you, talk to an investment advisor or tax professional.
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