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.

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.

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).

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.