What is a Tax-Deferred Savings Plan
A tax-deferred savings plan is a savings plan or account that is registered with the government and provides deferral of tax obligations. Tax-deferred savings plans may defer taxable income earned within the account either until withdrawal or until a particular date.
BREAKING DOWN Tax-Deferred Savings Plan
Essentially, tax-deferred savings plans allow an investor to use taxes for investing, taxes which would have otherwise gone to the government. In the end, the taxes are paid, but not before the funds are used to make more money. Tax-deferred savings plans are used most commonly in retirement savings accounts such as IRAs, 401(k)s, 403(b) plans, 457 plans, tax-deferred annuities, U.S. savings bonds, and RRSPs, but are also available for education savings plans and other accounts.
The IRA and 401(k)
With regular brokerage accounts, the IRS taxes investors on any capital gains realized from selling profitable investments. However, tax-advantaged plans allow an individual’s investing activities to be tax-deferred. Traditional Individual Retirement Arrangements (IRAs) and 401(k) plans are examples of tax-deferred accounts in which earnings on investments are not taxed every year. Instead, tax is deferred until the individual retires, at which point s/he can start making withdrawals from the account. Withdrawing from a traditional IRA without penalty is allowed once the accountholder turns 59½ years old, otherwise, a 10% tax penalty is applied. Once s/he reaches 70½ years, s/he is required to start taking minimum withdrawals from the account.
A tax-deferred annuity is an insurance contract that defers payouts, often for many years. A taxpayer that makes investments in this plan during his or her working years will see the interest earned in the account compound. Taxes on the earnings are not due for payment until the annuitized payouts begin. Tax-deferred annuities can be fixed, which offer a guaranteed rate, or variable, allowing the individual to choose from a variety of investments.
U.S. Savings Bonds
The Series EE bond and Series I bond are examples of U.S. savings bonds issued by the government that are tax-deferred. EE bonds, for instance, pay interest to bond investors for the duration of the bond’s life, which is usually 20 years. The coupon rates are assigned based on a percentage of the long-term Treasury rates at the time of issuance. While the interest received by investors is subject to federal tax, the tax is deferred until the year when the bond matures or is redeemed.
Savings bonds must be held at least one year before they can be redeemed by the bondholder. If they are held for less than five years, a penalty of three months' interest will be assessed when the bonds are redeemed. This means that a bond investor will lose the last three months of interest accrued on the bond if it is redeemed early.
In Canada, the Registered Retirement Savings Plan (RRSP) is an example of a tax-deferred savings plan. The RRSP shelters what would normally be taxable income earned within the account until withdrawal. All profits within the account, including interest, dividends and capital gains, are taxed as income only upon withdrawal.
Using tax-deferred investment accounts makes the most sense for an individual that is in a high tax bracket now and thinks s/he will be in a lower tax bracket in the future when s/he will be taking withdrawals. Furthermore, the government establishes these tax-advantaged plans to encourage private individuals to contribute money when it is considered to be in the public interest.