Tax Deferred

What is 'Tax Deferred'

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 gains. The most common types of tax-deferred investments include those in individual retirement accounts (IRAs) and deferred annuities. Tax deferral allows growth to be compounded on the portion of earnings not forsaken to investment taxation.

BREAKING DOWN 'Tax Deferred'

By deferring taxes on the returns of an investment, the investor benefits in two ways. The first is tax-free growth. Rather than paying tax on the current returns of an investment, tax is paid only at a later date, leaving the investment to grow unhindered. The second benefit of tax deferral extends to investments made during pre-retirement periods when earnings and taxes levied against working wages are typically higher than earnings in post-retirement phases. Withdrawals taken from tax-deferred investment accounts occur when a person is earning less taxable income and the tax rate realized by an individual is usually lower than the rate applied during the employment phase.

Qualified Tax-Deferred Vehicles

A 401(k) plan is a common vehicle offered by employers to grow employees’ retirement savings. Companies utilize a third-party administrator to manage contributions deducted from employee earnings. Employees choose to invest savings among various options: mutual funds, company stock or fixed-rate options. Gains attributed to securities held within the 401(k) do not apply to the employee’s taxable income. Contributions to qualified savings plans such as 401(k) accounts are made on a pre-tax basis, reducing taxable income received by the employee.

Withdrawals made from qualified retirement plans, generally after age 59.5, are taxed at the investor’s individual tax rate at the time of receipt. An investor with a 33% tax bracket on employment wages may pay 10 or 15% tax on amounts taken from 401(k) plans used to supplement retirement income from savings, interest and government subsidies. Tax-deferral and employer dollar-matching provisions encourage employees to set aside wages to grow a retirement nest egg, putting off receipt of funds to a period in which tax rates are theoretically lower.

Nonqualified Tax-Deferred Vehicles

A nonqualified tax-deferred investment does not reduce taxable income but allows capital gains and interest to grow unencumbered. Annuities are a popular insurance product embracing the benefits of tax deferral. While qualified retirement plans such as traditional IRAs limit contribution amounts to $5,500 annually, many annuities do not restrict contribution amounts. A $1 million fixed annuity contribution with a guaranteed 2% interest rate backed by an insurance company allows earnings to accumulate without being taxed by the Internal Revenue Service (IRS). The $20,000 in interest grows without the IRS levying taxes against the earnings, allowing the full amount to compound in the second year of the annuity contract. A money market investor in a 33% tax bracket, realizing the same interest rate, would owe $6,666 in tax to the IRS as earnings are treated as ordinary income. Interest received after age 59.5 avoids an IRS penalty for early withdrawal, which is a 10% assessment against interest earned.

RELATED TERMS
  1. Tax-Deferred Savings Plan

    A savings plan or account that is registered with the government ...
  2. Effective Tax Rate

    The average rate at which an individual or corporation is taxed. ...
  3. Deferred Annuity

    A type of annuity contract that delays payments of income, installments ...
  4. Tax Rate

    The percentage at which an individual or corporation is taxed. ...
  5. Deferred Account

    An account that postpones tax liabilities until a future date. ...
  6. Federal Income Tax

    A tax levied by the United States Internal Revenue Service (IRS) ...
Related Articles
  1. Financial Advisor

    Top Tips for Retirement Account Withdrawals

    Top things you need to know when it comes to managing the complex task of retirement account withdrawals.
  2. Retirement

    Not All Retirement Accounts Should Be Tax-Deferred

    It may be better to leave your assets exposed to the tax man when you're saving to retire.
  3. Personal Finance

    Retirement Savings: Tax-Deferred Or Tax-Exempt?

    There advantages and disadvantages to both types of savings accounts. Find out which one is right for you.
  4. Financial Advisor

    Tips for Tax-Efficient Retirement Plan Withdrawals

    Here's how advisors can help increase tax efficiency for clients who are withdrawing assets from retirement accounts.
  5. Financial Advisor

    Top Annuity Tax Deferral Strategies

    Annuities can provide tremendous tax advantages for retirement savers. Here are some tax deferral strategies to consider.
  6. Financial Advisor

    How to Pay Minimal Taxes on Retirement Assets

    Withdrawing and spending during retirement can be complicated. Here are some tips on how to manage the process in the most tax-efficient manner.
  7. Retirement

    Why are 401(k) contributions limited?

    Find out why contributions to 401(k) retirement plans are limited, including what the current contribution limits are and how limits encourage participation.
  8. Retirement

    How Yearly Taxes on 401(k) Accounts Work

    Learn how your contributions to traditional or Roth 401(k) accounts are taxed, either in the year of contributions or at withdrawal, depending on the type.
  9. Retirement

    Personal Pensions: Repackaging The Annuity

    Discover an investment that can provide a stable income once you've left the work force.
  10. Retirement

    Best Ways to Save For Retirement Without an IRA or 401(k)

    Learn the most common types of savings vehicles used to accumulate money for retirement outside employer-sponsored 401(k)s or IRA accounts.
RELATED FAQS
  1. What are the most common deferred tax assets used by individuals?

    Use these deferred tax assets to reduce your tax liability and grow your assets simultaneously. Discover the most common ... Read Answer >>
  2. How do deferred tax assets help in meeting retirement goals?

    Learn how tax deferred assets can help individuals achieve long-term financial goals such as retirement and how they differ ... Read Answer >>
  3. How do gains from my 401(k) figure into my taxable income?

    Understand what a 401(k) is and how it's used to help employees save for retirement. Learn how gains from a 401(k) figure ... Read Answer >>
  4. Are variable annuities tax deferred?

    Learn how variable annuities are tax-deferred, but also understand some of the less advantageous tax implications from purchasing ... Read Answer >>
  5. Are annuities qualified or nonqualified retirement instruments?

    Learn the basics of annuity investments and the tax-deferral they offer, and discover the differences between qualified and ... Read Answer >>
  6. How is compound interest taxed?

    Understand the concept of compound interest as opposed to simple interest and learn the usual tax rate at which compound ... Read Answer >>
Hot Definitions
  1. Brazil, Russia, India And China - BRIC

    An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...
  2. Brexit

    The Brexit, an abbreviation of "British exit" that mirrors the term Grexit, refers to the possibility of Britain's withdrawal ...
  3. Underweight

    1. A situation where a portfolio does not hold a sufficient amount of a particular security when compared to the security's ...
  4. Russell 3000 Index

    A market capitalization weighted equity index maintained by the Russell Investment Group that seeks to be a benchmark of ...
  5. Enterprise Value (EV)

    A measure of a company's value, often used as an alternative to straightforward market capitalization. Enterprise value is ...
  6. Security

    A financial instrument that represents an ownership position in a publicly-traded corporation (stock), a creditor relationship ...
Trading Center