What is a tax deferral?

Here’s what you need to know about postponing your tax payments

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When investing, it's critical to consider how taxes will impact your earnings. The goal is to minimize taxes while maximizing your investment's growth. There are a few ways you can do this, one of the most effective ways being tax deferral. It's an efficient strategy to grow and compound your money without dealing with taxes simultaneously.

Here, we explore what tax deferral is and how to make the best out of it.


Key insights

Tax deferrals allow your investment earnings, such as capital gains, dividends and interest, to accumulate tax-free. You start paying the taxes once you withdraw the money.

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401(k) plans, annuities and individual retirement accounts (IRAs) are examples of tax deferrals.

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Tax deferrals reduce your tax bill now, and even better news is that by the time you become liable for paying the taxes after retirement, you will likely be in a lower tax bracket.

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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.

Taxpayers are only required to pay taxes for their contributions and earnings once they withdraw their money or receive their income.

Tax deferrals are beneficial when held until retirement when taxpayers aren't subject to withdrawal penalties or premature tax. Also, the taxpayer will likely be in a lower bracket after retirement, owing even less tax. Lastly, contributing to qualified tax deferral accounts, such as traditional IRAs, allows you to deduct 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 up for the future. Each account has its benefits and eligibility conditions. Here are a few common examples of tax-deferred accounts.

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 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 up more for retirement. Like a 401(k) or 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?

Pros and cons of tax deferral

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

Pros

  • Tax deduction
  • Compounding benefit
  • Lower taxation
  • No taxes on investment gains

Cons

  • Contribution caps
  • Penalties for premature withdrawals
  • Mandatory withdrawals

Tax deferral vs. tax exemption

Tax deferral accounts allow you to deduct maximum contributions from your taxable income, 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-exempt account contributions are after-tax dollars, meaning withdrawals are tax-free. Tax-exempt accounts provide future benefits, meaning there's no immediate tax advantage. 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 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 close to retirement).

Owe the IRS thousands? See if you qualify for relief.

    FAQ

    Do I have to pay penalties if I withdraw from a tax-deferred account early?

    Yes, you are penalized by the IRS if you withdraw money before the minimum age, which is 59½ years. You must also pay taxes on the withdrawn money since you didn't wait.

    Can tax deferral help me save money in the long run?

    Yes, the early withdrawal penalty can be a powerful tool to stop you from tapping into your retirement savings to cover your current expenses. This discipline is critical in saving money in the long run.

    Is tax deferral a good thing?

    Yes, if you want to enjoy tax breaks in the current year and deal with tax liability during withdrawals.

    Bottom line

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

    Factors like 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.


    Article sources
    ConsumerAffairs writers primarily rely on government data, industry experts and original research from other reputable publications to inform their work. Specific sources for this article include:
    1. IRS, “401(k) Plans.” Accessed March 2, 2024.
    2. IRS, “Traditional IRAs.” Accessed March 2, 2024.
    3. IRS, “Annuities - A Brief Description.” Accessed March 2, 2024.
    4. IRS, “How Much Salary Can You Defer if You’re Eligible for More than One Retirement Plan?” Accessed March 2, 2024.
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