What Is a Tax Deferral?

How does tax deferral work?

Tax deferral refers to delaying tax payments on asset growth until it’s fully compounded and ready for withdrawal. This means that instead of paying taxes upfront during contributions, you pay them when withdrawing funds.

“Tax deferrals can be wildly advantageous, especially when the deferral timeline is longer; for example, beginning 401k contributions early in one’s career to allow for longer tax-deferred compounded growth,” says Thomas Schulte, director of financial planning at Napier Financial in Braintree, Massachusetts.

“Leveraging these tax-deferred accounts typically allows for lower income tax liabilities in one’s working/accumulation years and offers flexibility around investment selection as these accounts avoid capital gains,” Schulte says.

Many types of qualified retirement account plans allow individual taxpayers to defer taxes on contributions and earnings. Qualified annuities can also give you deferred tax privileges. Annuities with lengthy accumulation periods maximize the benefits of tax deferrals.

Retirement accounts and potential tax deferral benefits

Taxpayers are only required to pay taxes for their contributions and earnings once they withdraw their money or receive their income. Prospective tax deferral benefits on retirement accounts include the following:

• In retirement, taxpayers aren’t subject to retirement account withdrawal penalties or premature tax.
• The taxpayer will likely be in a lower bracket after retirement, owing even less tax.
• Contributing to qualified tax deferral accounts, such as traditional IRAs, allows you to claim your contribution as a deduction when filing returns, reducing your taxable income.

Types of tax deferral

There are several types of tax-deferred investments taxpayers can set up to enjoy tax relief and save for the future, each with its own benefits and eligibility conditions. Here are a few common examples of tax-deferral types.

Retirement accounts

Traditional IRAs, 401(k) plans and annuities allow you to save for retirement while deferring taxes on your contributions.

401(k) plans

A 401(k) is a qualified profit-sharing account in which employees contribute a portion of their salary to individual accounts.

The salary deferrals are excluded from the employee's taxable income, while the contributions and earnings are included in the taxable income after retirement.

Traditional IRAs

If you're not eligible for a 401(k) or you simply want an additional retirement account, an individual retirement account (IRA) is a good choice.

There are two major types of IRA accounts: Roth and traditional. The latter allows taxpayers to contribute pre-tax dollars, meaning tax is paid when withdrawals begin.

Annuities

If you've maxed out your 401(k) plan and IRA contributions for the year, qualified employee annuities can help you save more for retirement. Like a 401(k) or an IRA, if you purchase an annuity with pre-tax dollars, you’ll pay taxes for the contribution and interest when withdrawing the funds.

If you buy annuities with after-tax dollars, only your interest will be taxed when you start receiving payments.

» MORE: Annuity vs. IRA: What’s the difference?

Other tax deferral scenarios

Tax deferral isn’t limited to retirement accounts; you can defer taxes on some other investments as well.

1031 exchange

A 1031 exchange, or “like-kind exchange,” is a real estate investment strategy that allows you to postpone paying capital gains taxes. You can take advantage of this if you sell an investment property and then purchase a similar one within 180 days.

Installment sale

An installment sale occurs when you sell a property and receive at least one payment after the tax year when the actual sale occurs. This allows you, the seller, to pay tax on your gains proportionally instead of all at once.

Stock options

If you have stock options available through your employer, they may not be considered taxable income until you sell them.

Pros and cons of tax deferral

Deferring tax liability until retirement is a smart way to minimize taxes and maximize retirement savings. But to enjoy the benefits of tax deferrals, you must abide by certain rules and restrictions. Consider the following pros and cons of tax deferral before you set up an account.

Tax deferral vs. tax exemption

What’s the difference between tax deferral accounts and tax-exempt accounts? While both have benefits, which one is best for you likely depends on your financial situation.

Tax deferral

Tax deferral accounts allow you to deduct maximum contributions from your taxable income, thereby lowering your tax liability. The general idea is that tax benefits in the current year outweigh any future implications during withdrawals. Also, as a higher-income earner, your tax bracket will be lower after retirement, reducing the amount of tax you owe.

Tax exemption

Tax-exempt account contributions are after-tax dollars, meaning withdrawals are tax-free. There’s no immediate tax advantage to tax-exempt accounts, as they provide future benefits. Examples of tax-exempt accounts are Roth IRA and Roth 401(k).

Tax-exempt accounts are ideal for young adults since they're in the early stages of their professional lives and their tax brackets are low. As they advance in their careers, their tax brackets increase. Tax-exempt accounts allow them to access investment and capital growth without tax concerns.

» MORE: Using your 401(k) to pay off debt: What are your options?

Which account is best for you?

If you're in a lower tax bracket now and you expect to advance to a higher bracket, a tax-exempt account will help you avoid future tax liability.

On the other hand, a tax deferral account will lower the tax you owe if you're currently in a high tax bracket and expect to be in a lower bracket. This is most applicable for individuals who are close to retirement.

Bottom line

Tax deferral can be seen as "delayed tax." You'll pay the taxes for your investment after it’s fully compounded and due for withdrawal. Although the terms and conditions, such as penalties for early withdrawals, may seem harsh, the benefits are substantial, too.

Factors including your retirement timeline and tax bracket influence how you benefit from the account. Ensure you compare all the options and choose the one that suits your needs.