What Does Tax-Deferred Mean?

Last updated 03/28/2024 by

Summary:

Tax-deferred accounts allow investments to grow tax-free until some point in the future (sometimes indefinitely). This allows assets to grow faster and reduces tax liability. Investors should consider taking advantage of tax-deferred accounts whenever available.

“Nothing is certain except death and taxes.” Ben Franklin was not just flying kites and extolling the virtues of wine. He knew the government would have its hand out expecting to be paid and they wouldn’t go away. Jump 200+ years later and it may seem like not much has changed.

The government still wants its taxes, but you can get a temporary reprieve if you meet certain requirements. The government wants revenue but it also wants you to — among other things — save for your own retirement and pay for your family’s college tuition fees, and it’s willing to give you a powerful incentive. If you put aside dollars from your current income, they will defer taxes on those dollars. The deal gets even better: They will also defer taxes on the dollars those dollars earn!

Typically, you should jump at this opportunity but remember: The government hasn’t said they don’t want to be paid those taxes, they only said they will wait.

Compare Brokerage Services

Compare multiple vetted providers. Discover your best option.

Compare Brokerages

What is the purpose of tax-deferred accounts?

It’s getting harder and harder to make ends meet. The first person with their hand out for their share of your taxable income is not a person, it’s the federal government. If you can legally delay paying them, that’s a good thing.

Tax deferral enters the picture because the government wants Americans to save for their own retirement. They offer the ability to defer taxes on both a portion of your income and taxes on the appreciation of those assets as an incentive.

When you set money aside in individual retirement accounts (IRAs) or 529 accounts, or other tax-deferred accounts, you continue to own and control your money. You don’t pay income taxes (unless there is a withdrawal) and you get to decide how it is invested. You will eventually need to pay taxes on those dollars, but it makes sense to push that day off as long as possible.

What is tax deferral?

Imagine if the Internal Revenue Service (IRS) said: “You are living on borrowed time.” That sounds scary because you have heard that line used in films, usually after the character survives a near-death experience. Tax deferral is a similar concept. The government normally expects to collect taxes immediately, but under certain circumstances, they will allow you to defer paying taxes.

Deferring taxes usually involves restricting your access to your own money. It’s yours, but you can’t spend it.

Why is tax deferral a good deal for investors?

Generally speaking, it is a good idea to put off paying taxes as long as possible. There are many reasons this strategy makes sense for investors. The taxpayer might be in a lower income tax bracket when they retire. It is possible (but not likely) income tax rates might decline in the future.

Compounding in a tax-deferred account is a major benefit! If your retirement savings can grow undisturbed by taxes for decades, your original principal gains interest, and your earned interest earns more interest.

Tax-deferred vs regular accounts: An example

It is hard to build wealth in a taxable environment. Consider the hypothetical example of a single taxpayer intending to set aside $6,000 as a nest egg. This taxpayer is age 30 and earns over $86,376 a year, putting them in the 24% marginal income tax bracket. Before they opened an account with their $6,000, the government asks for its 24%. Now the initial principal is $4,560.

Let us assume their investment earns an average rate of 8% annually. A further assumption is the money has been invested in a money market mutual fund paying interest. During the first year, the $4,560 returns $480 in interest. At the end of the first year, the government has its hand out, expecting their 24% or $115.2. Their gain is reduced to $364.8. The taxpayer is taking four steps forward and one step back.

Now we consider the taxpayer setting aside $6,000 as their first annual contribution to their Individual Retirement Account (IRA). All of the $6,000 goes to work for them and that includes any earned interest. This can build up over the years as the example below illustrates.

Tax revenue and tax-deferred accounts

“Pay me now or pay me later.” You’ve heard that line before. The government uses the tax code to drive behavior. In this case, the government wants to encourage people to put money aside for their own retirement. Their reasoning is Social Security is meant to supplement your retirement income, not replace it.

To encourage people to save for retirement the government gives taxpayers an incentive. If you designate a certain amount of your income as retirement savings, the government won’t tax you on that portion of your income immediately.

Here is a hypothetical example explaining why this is a good deal for the government. Let us go back to that single taxpayer, age 30 who is earning over $ 86,376. This puts them in the 24% marginal tax bracket. They make the maximum allowed contribution to their Individual Retirement Account (IRA), putting aside $ 6,000. The government is forgoing $ 1,440 in federal income taxes they could have collected immediately.

Now assume their money grows at an average rate of 6% annually. The Rule of 72 tells us their money theoretically doubles every 12 years. When they reach age 66 they have completed three cycles of 12 years. Their original $ 6,000 has grown to $ 48,000. Because the federal government waited over three decades, they can tax $48,000 instead! If we assume a 24% marginal tax rate, the government can collect $ 11,520 in tax when the taxpayer accesses their money.

If the taxpayer instead had invested in stocks within a taxable account at age 30 and didn’t sell until age 66, the federal government would be collecting long term capital gains tax, currently at 15%. Because the government allowed tax deferral on that portion of income, they collect tax at the higher marginal tax bracket, currently 24%.

Tax deferral through retirement accounts

The easiest way for taxpayers to enjoy the benefits of a tax-deferred investment is by saving for retirement in one of several tax-deferred accounts. Here are a few examples of types of tax-deferred accounts.

Individual Retirement Account (traditional IRA)
This is the account that started it all! Currently, individual taxpayers are allowed to contribute up to $6,000 a year as savings for retirement. Taxpayers age 50+ who missed payments are able to increase the amount to $7,000 because they are making catch-up contributions.
401(k) plans
These are defined contribution plans set up by private sector employers. These are employer-sponsored retirement plans. The taxpayer contributes to the plan from their before-tax income. In many cases, the employer contributes matching funds. There are thresholds for each party. The match for employers might be $0.50 for every $1.00 the employee contributes.
403(b) plans
This is the public sector version of the 401(k) plan. The concept is similar.
SEP plans
The full name is Simplified Employee Pension plans. If you are a one-person business or your firm is small, this is the easy way to set up a retirement plan.
ROTH IRA
This is a variation of the original IRA concept. Instead of contributing pretax dollars, you contribute after-tax dollars from your income. When you withdraw money after age 59 1/2, no taxes are levied.

Tax deferral through insurance products

Suppose we make a few assumptions: You can save $6,000/year in an individual retirement account. You can save $20,500/year in a 401(k) account with some matching dollars from your employer. How is that supposed to support you if you are earning $250,000 a year and spending everything? You may want to setup your own private pension.

Non-qualified annuities fit that description. They are an insurance product funded with after-tax dollars. The life span of an annuity starts with the accumulation phase. Your money grows tax-deferred. When you are ready to start collecting income, the annuity transitions into the distribution phase, generally paying you a fixed amount for life. The payments you receive are considered a combination of interest and principal, the first is taxed, the second is not.

Whole life insurance is another insurance product where money grows in a tax-deferred environment. If the policy owner dies, the death benefit payable to the beneficiaries is usually tax free. If the policy owner has built up significant cash value, they can turn the life insurance policy into an income-producing product by transitioning the life policy into an annuity through a 1035 exchange.

Can I do this on my own?

Yes, it is now easier than ever to set up and manage your own tax-deferred accounts. Of course, you can’t keep your tax-deferred investments under your mattress. You need a tax-deferred account, such as retirement and educations savings accounts. These are easy to setup through a bank, brokerage firm or other financial services company. Your company 401(k) plan is another option. The brokerages below all provide the options of investing in tax-deferred accounts.

It also makes sense to get investment advice from a qualified financial services professional if you are not an experienced investor. They can help you develop a financial plan that includes a focus on retirement planning. Investment advisors an help you invest within your Individual Retirement Account and provide advice concerning your 401(k) or 403(b) plan investments. These investment advisors are a good place to start if you’re in the market for an investment firm.

Deferred income at work

Highly-paid employees are compensated in many ways including salary, bonuses, and stock options. There may be circumstances when it makes sense to not get paid in the current tax year. When an employee chooses to get paid later rather than immediately, it’s referred to as deferred compensation. These plans are often called “Top Hat” plans.

This strategy has it pros and cons but the tax advantages are obvious. You aren’t taxed immediately because you aren’t paid immediately. There is a major disadvantage though. Unlike traditional retirement plans, the deferred compensation is a debt of the company, not money set aside in a retirement account. If the company goes bankrupt, you are a creditor.

Pro Tip

Take full advantage of every opportunity to defer taxes on portions of your current income. Setting aside funds for retirement allows you to invest for the long term, enjoying the benefits of tax deferral.

FAQ

Why is tax-deferred better?

There are several reasons keeping money in a tax-deferred account is better than keeping it in a taxable account. You can put before-tax dollars, not after-tax dollars, to work. The growth of your money is also tax deferred. You may be in a lower tax bracket when you choose to access your retirement assets.

How do I pay deferred tax?

Deferred tax is paid when you access the funds. This is often done through retirement plan distributions and withdrawals.

Why are federal employees’ taxes being deferred?

In August of 2020, the White House issued an executive memo deferring payroll taxes. Lasting a few months, it was meant as a payroll boost for workers during the pandemic. The government implemented it but most of the private sector did not. This deferral only lasted for a few months, then the deferred taxes needed to be repaid. They were due to be repaid by the end of April 2021.

Should I defer my self-employment tax?

The Coronavirus Aid, Relief, and Economic Security Act allowed self-employed individuals to defer some Social Security taxes for 2020, catching up during 2021 and 2022. This sounds tempting, but the deferral period is only for a short amount of time. If you can afford to pay, you probably should pay them on time.

Key takeaways

Tax deferral is an incentive the government provides to encourage people to save for their own retirement.
Retirement accounts are setup to hold these funds and let them grow in a tax-deferred environment.
The government collects taxes when these funds are removed.
The funds you remove are taxed as ordinary income.

Bryce Sanders

Bryce Sanders is president of Perceptive Business Solutions Inc. He provides HNW client acquisition training for the financial services industry. His book, “Captivating the Wealthy Investor” is available on Amazon. Bryce spent twenty years with a major financial services firm as a successful financial advisor. He has been published in 40+ metro market editions of American City Business Journals, Accountingweb, NAIFA’s Advisor Today, The Register, LifeHealthPro, Round the Table, the Financial Times site Financial Advisor IQ and Horsesmouth.com.

Share this post: