Tax-deferred status refers to investment earnings that accumulate without being taxed until the investor withdraws the profits. Some common examples of tax-deferred investments include individual retirement accounts (IRAs) and deferred annuities. Interest, dividends, and capital gains are earnings that can be considered tax-deferred earnings.
Key Insights on Tax-Deferred Investments
- Tax Benefits: Investment earnings, such as interest, dividends, or capital gains, grow tax-free until withdrawal.
- Tax Efficiency: Investors benefit from delaying tax payments, often realizing these savings during lower-tax-bracket retirement years.
- Example: A 401(k) plan is a popular tax-deferred vehicle aiding retirement growth.
Discover the Benefits of Tax Deferral
Investors reap the advantages of the tax-free growth of earnings through tax-deferred investments. The tax savings can be considerable for investments held until retirement, likely resulting in a lower tax bracket and avoiding premature tax and withdrawal penalties.
Investing in qualified products such as IRAs allows participants to claim some or all of their contributions as deductions on their tax returns. This immediate tax benefit, coupled with lower future tax rates, makes tax-deferred investments inviting.
Qualified Tax-Deferred Vehicles
A 401(k) plan is an employer-sponsored defined contribution account meant to boost employee retirement savings. A third party typically manages contributions deducted from employee earnings. Employees invest these contributions in options like equity funds, company stock, money market equivalents, or fixed-rate choices.
Contributions to 401(k) accounts are made on a pre-tax basis, reducing employees’ taxable income in the contribution year and typically resulting in lower tax liability. However, distributions from these plans are taxable as ordinary income if withdrawn before age 59½, with potential early withdrawal penalties.
Exploring Nonqualified Tax-Deferred Vehicles
Nonqualified plans accept post-tax contributions, which means they do not reduce your taxable income in the contribution year. However, their earnings can still grow tax-free if the plan is tax-deferred.
Annuities and other nonqualified products often lack contribution limits, contrasting with traditional IRAs, which have an annual contribution limit of $6,500 for 2023, with an additional $1,000 for individuals aged 50 or older as a catch-up contribution.
Non-Tax-Deferred Retirement Accounts
Contributions to Roth accounts are not tax-deferred. Taxes are paid in the contribution year with no deductions allowed. However, Roth accounts are free from required minimum distributions, allowing tax-free withdrawals in retirement.
What Is an Elective Deferral Limit?
Elective deferrals are employer contributions to retirement plans not included in employees’ taxable income. The IRS sets limits: $22,500 for 2023, increasing to $23,000 in 2024. Limits are higher for those aged 50 or older.
Understanding Required Minimum Distributions
Required minimum distributions (RMDs) ensure the IRS eventually collects taxes on retirement accounts like IRAs and 401(k)s. RMDs top out by age 72 if born before December 31, 2022, and age 73 if born afterward.
Conclusion
“Deferred” essentially means delayed. Though you’ll eventually pay taxes on this money, choosing the appropriate time—whether now or later—can significantly affect your financial wellbeing. Consult with a financial advisor to determine the best strategy for your circumstances.
Related Terms: Roth IRA, 401(k), capital gains, dividends, elective deferral, required minimum distribution.
References
- IRS. “Topic No. 451, Individual Retirement Arrangements”.
- IRS. “401(k) Plans.”
- IRS. “Topic No. 424, 401(k) Plans”.
- IRS. “Topic No. 558, Additional Tax on Early Distributions From Retirement Plans Other Than IRAs”.
- IRS. “401(k) Limit Increases to $22,500 for 2023, IRA Limit Rises to $6,500”.
- IRS. “401(k) Limit Increases to $23,000 for 2024, IRA Limit Rises to $7,000”.
- IRS. “Roth IRAs”.
- IRS. “Retirement Plan and IRA Required Minimum Distributions FAQs”.
