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Advantages of Tax Deferred Plans

Learn how tax deferred plans work

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A tax deferred account is an incredibly valuable device for effective retirement saving.

What does it mean if something is tax deferred?

An account is tax deferred if there is no tax due on income earned in the account.

What are examples of tax deferred accounts?

A regular IRA (also known as traditional) IRA is tax deferred. An annuity and the cash surrender value of a whole life insurance policy also operate as tax deferred accounts. A Roth IRA is not tax deferred; it is a tax-free account.

How is a tax deferred account different from a tax exempt account?

Individuals can't establish tax exempt accounts. However, they may invest in bonds which pay tax exempt interest. Typically such interest is exempt from federal tax. However, if the bond represents the debt of a state other than the individual's residence, that interest will be taxable on his state income tax return.

How does it work if an account is not tax deferred?

All investments have the potential to pay income, increase in value, or both. Income comes from two primary sources: interest and dividends. If an investment is held in a taxable account, the income is added to the owner's taxable income for the year and results in a higher tax liability. Any sales of assets held in a taxable account which are sold for more than what was invested will also result in increased income and income tax. No tax would be due if the same investments were held in a tax-deferred account - a significant advantage to holding investments in such a tax deferred account.

Until when is tax deferred?

One day, you will pay the tax. The tax liability is triggered not by the investment performance, however. Instead, you will owe tax based on the amount of money you distribute to yourself, typically to pay for things you may want or need. As such, in an ideal situation the income is not taxed until retirement, when you may be in a lower tax bracket. Even if your tax bracket does not decline in retirement, you are still likely to benefit from a tax deferred account since it is far better to pay taxes in the future than in every year between now and when you would otherwise pay them.

Will I get a tax deduction?

Note that some tax deferred accounts, such as a 401(k) or deductible IRA provide for a tax deduction in the year you make the contribution. Not all tax deferred accounts create such a deduction, however. In either case, the tax deferred account provides for the deferral of tax during each subsequent year.

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