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Tax-deferred investments are savings put into an account that is taxed when the money is withdrawn, rather than when it is contributed. Common examples of tax-deferred investments include individual retirement accounts (IRAs), 401(k) accounts, and annuities. For people planning to save money for a long-term goal, tax-deferred investments may provide greater total funds upon withdrawal than regularly taxed investments.
It is important to understand the difference between tax-deferred and tax-exempt. A tax-exempt account is free from all taxes, and is a relatively rare type of investment. Tax-deferred accounts are far more common, and simply put off paying taxes on the account until the investment is withdrawn. Depending on the circumstances of the withdrawal and type of account, deferred accounts can be good or bad.
There are two major factors that can help tax-deferred investments work in the favor of the investor. The first is that, since a portion of the money is not regularly withdrawn to pay for annual taxes, more of it is working for the investor. More money in the account leads to more interest earned, which in turn leads to a greater balance by the time of withdrawal.
The second primary benefit to tax-deferred accounts is that they are often meant to be withdrawn after retirement. When a person retires, the reduction in income often leads to a position in a lower tax bracket. This means that the investment, when withdrawn after retirement, will be taxed at a lower rate than while the account holder had a significantly higher income.
IRAs and Roth IRAs are popular types of tax-deferred investments meant for retirement. Traditional IRAs may even allow contributions to the account to be tabulated before taxes, meaning that the amount of annual contribution may be higher, thus driving up the principle balance in the account. With a Roth IRA, pre-tax contributions are not allowed, but account holders may be able to qualify for tax-free withdrawals in some cases.
A 401(k) is a common type of employee investment account that may be tax-deferred. In addition to sometimes allowing pre-tax contributions, like a traditional IRA, employers may offer matching contributions to reduce the contribution burden on the employee and still help grow the account quickly. Not all employers offer investment account plans, and those that do may have individual rules and regulations.
Annuities are similar to life insurance policies in that they are a deal struck between an account holder and an insurance company. These accounts, which are almost always tax-deferred, have a set period of years that the account holder pay into the account, followed by a payout phase where regular, set payments are given to the account holder for a given period of time. These accounts provide death benefits, so that the account holder's heirs will receive the annuity payouts if the account holder dies during the payout phase.
Tax-deferred investments can have a negative impact on account balance in certain circumstance. Most commonly, if the account holder makes an early withdrawal, penalty fees and higher tax bracket rates may reduce the balance by a considerably larger percentage than after the account has reached maturity. In this case, having a higher balance because of a tax-deferred system can be detrimental, as it may drive up the taxable portion of the total amount.
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