What Is a Tax-Deferred Savings Plan?
A tax-deferred savings plan is an investment account that allows a taxpayer to postpone paying taxes on the money invested until it is withdrawn after retirement. The best-known such plans are Individual Retirement Accounts (IRAs) and 401(k) plans.
- The 401(k) plan and the IRA account are the two most common types of tax-deferred savings plan.
- In both cases, the money saved by the investor is not taxed as income until it is withdrawn, presumably after retirement.
- Since the money saved is deducted from gross income, the investor gets an immediate break on income tax.
Tax-deferred savings plans are qualified by the Internal Revenue Service (IRS). That is, the IRS allows the taxpayer to pay money into the plan and subtract that amount from his or her taxable gross income for that year. The taxes on the contribution and its investment returns will be due only when the money is withdrawn after retirement.
Understanding the Tax-Deferred Savings Plan
The tax-deferred savings plan was approved by the federal government as a way to encourage Americans to save for retirement. An individual may contribute a portion of pre-tax earnings to an investment account.
There are several benefits to the individual:
- The person's taxable earned income is reduced by the amount contributed to the account. This immediately lowers the federal taxes owed by the individual for that year.
- The money is then invested in the individual's choice of mutual funds or other types of investments, with a balance that grows steadily until retirement. The pre-tax money boosts the amount invested, and its potential growth over time.
- After retiring, the individual can draw from the fund for income. The withdrawals are taxable as regular income.
Tax-Deferred 401(k) and IRA Plans
Most big companies and many small ones offer their employees a 401(k) plan for tax-deferred retirement savings. There are similar vehicles such as the 403(b) and the 457 plan for public services and government employees.
The interest on some U.S. Savings bonds is tax-deferred and may be tax-exempt if the money is used for some educational expenses.
When an employer sponsors the plan one other big benefit is possible. Some employers match a portion of the employee's contribution up to a certain level. A 3% match is typical for employers who offer it.
Self-employed people and virtually anyone else with some amount of taxable income can open an IRA account. These are available through banks and brokerages.
In any case, the individual investing in a tax-deferred savings plan typically has a wide range of investment options to choose from.
In addition to 401(k) plans and IRAs, several other types of investment offer tax deferral.
A tax-deferred annuity, also called a tax-sheltered annuity, is a long-term investment account that is designed to provide regular income payments after retirement, similar to a pension. This type of annuity is available through insurance companies.
The investor pays into the annuity account over a period of years in order to build a balance that will be paid out in installments after retirement. The contributions are not tax-deferred but taxes on the earnings in the account are not due for payment until the annuitized payouts begin.
Tax-deferred annuities can be fixed, offering a guaranteed rate of return, or variable, allowing the individual to choose from a variety of investments that may increase (or decrease) the payments received.
Tax-Deferred U.S. Savings Bonds
The Series EE bond and the Series I bond are types of U.S. savings bonds issued by the government that are tax-deferred and have an additional tax benefit if used to pay educational expenses.
Series EE bonds pay interest for the duration of the bond’s life, which is usually 20 years. Series I bonds pay interest for up to 30 years.
In either case, the interest paid to the bondholder is not taxed until the bond reaches its expiration date or is redeemed.
In addition, an education tax exclusion shields the interest payments from income taxes if they are used to pay for educational expenses.
The Registered Retirement Savings Plan (RRSP) is an example of a tax-deferred savings plan for Canadian taxpayers. The RRSP shelters what would normally be taxable income earned within the account until money is withdrawn.
All profits, including interest, dividends, and capital gains, also are tax-deferred until they are withdrawn.