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What Are Tax-Deferred Accounts?

The earnings in a tax-deferred account remain tax free until the investor makes a withdrawal.
Tax-deferred accounts are often meant to be withdrawn after retirement.
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  • Written By: Florence J. Tipton
  • Edited By: A. Joseph
  • Last Modified Date: 06 August 2014
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Tax-deferred accounts are investment vehicles that accumulate interest, dividends or capital gains — earnings that remain tax-free until the investor makes a withdrawal, usually at the time of retirement. The most common tax-deferred accounts are traditional individual retirement accounts (IRAs), retirement investments established through employers, simplified employee pension (SEP) accounts and deferred annuities. Earnings on tax-deferred investments have unrestricted growth potential, and withdrawals typically occur when the investor has a lower tax rate.

Traditional IRAs are retirement plans that provide annual limits for individuals to invest pretax income. Commercial banks and retail brokers act as custodians for IRAs. Contributions are invested in mutual funds, stocks, bonds or other financial assets. Distributions from traditional IRAs are subject to income tax deductions similar to ordinary income, unlike accounts that have tax-free distributions.

In some countries, employers can establish tax-deferred accounts for eligible employees. An example is the 401k plan in the United States. Employees make salary deductions on a pre-tax or post-tax basis, and taxes are deferred on the earnings. Employers can match employee contributions and add profit sharing to the plan.

Government regulations typically limit the amount of salary contributions that an employee can make. Employees may have the option to select investment products or have an investment firm manage the assets. These plans also define the retirement age for withdrawals. Restrictions and penalties apply if an employee withdraws money before retirement.

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The Simplified Employee Pension (SEP) account has two types of plans which qualify as tax-deferred accounts. The two categories are defined contribution plans and defined benefit plans. These employer-sponsored plans are easier for small businesses to administer than a conventional pension plan.

A defined contribution plan is an individual account in which either an employee or employer contributes to the plan. Market conditions determine the payout of a defined contribution plan. The employer maintains a fund for participating employees in a defined benefit plan. This fund generates a monthly check based on an agreed amount when the employee retires.

An investor can receive delayed installments or a lump sum payment from a deferred annuity. Savings accrue in these tax-deferred accounts with a variable or fixed interest rate. Earnings are taxed at the time of withdrawal.

A person who has a deferred annuity determines the date payment will begin. Payments can be deferred until retirement or begin sooner. A deferred annuity also has a death benefit that guarantees that the principal and investment earnings are paid to the assigned beneficiary.

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Discuss this Article

ceilingcat
Post 4

@JaneAir - I suppose it is a gamble. But it sure would be nice to pay a little bit less in taxes now and be able to make some investments.

I guess everyone has to choose the right savings/retirement plan for themselves. Personally I think the best idea is to talk to a financial planner and get all the details about the different kinds of accounts. A lot of people don't know the difference between the many types of retirement accounts out there. I think at that point it's a good idea to consult an expert!

JaneAir
Post 3

Tax-deferred accounts sound great in theory. But keep in mind that you will eventually have to pay the taxes on that money!

I actually feel like you're sort of taking a gamble if you use a tax-deferred account for your retirement savings. Especially for a young person in their 20s. You have no idea what the taxes are going to be like when you get to retirement!

I would rather play it safe and just invest my after tax income so I don't have to worry about paying taxes later.

icecream17
Post 2

@Comfyshoes -For me the IRA individual retirement account is a better alternative to the 401K account if you can only afford to fund one of these accounts. The reason is simple. With a IRA retirement account you are able to choose the funds and investment vehicles that you would like, but with a 401K you are really stuck with whatever choices the company offers.

I always invest up to the company match, and then I fund my IRA. I love having a self directed IRA account because I want to make the investment choices myself. I like doing my own research and feel more in control of my finances when I pick my own funds.

comfyshoes
Post 1

I know that the Roth individual retirement accounts have income restrictions, but I have to say that if you are able to invest in this type of account it is probably one of the best retirement account options out there.

Although the individual retirement account or IRA allows you to save for retirement in a tax sheltered account, the problem is that when you withdraw funds from this account at retirement it is taxable.

The Roth IRA account forces you to have to pay taxes today on your initial contributions, but the money in the account grows tax free so that when you actually retire and withdraw money you will not have to pay any taxes on that money.

Also, with the Roth IRA account, they do have provisions which allow you to withdraw your original contribution without penalty for other expenses like buying a home or paying for college.

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