What is Tax Deferred?

Nicole Madison
Nicole Madison

The term tax deferred refers to the postponement of paying taxes on earnings until a later date. In an investment situation, money allowed to grow in a tax deferred account is not taxed until it is withdrawn. Some examples of investments on which tax payments are deferred are individual retirement accounts (IRAs), annuities, and certain types of bonds.

A tax deferred annuity can be taken as an automatic payroll deduction.
A tax deferred annuity can be taken as an automatic payroll deduction.

Tax-deferred investments can provide investors with valuable savings. Essentially, tax-deferred investments allow investors to save money in the present, dealing with taxes in the future. To take advantage of tax deferred savings, an investor can choose to place pre-tax dollars, up to a certain amount, in various investment products. By doing so, the investor lowers his or her current taxable income and may be able to benefit from taxation at a lower tax bracket.

Tax deferred investments can provide investors with valuable savings.
Tax deferred investments can provide investors with valuable savings.

Sometimes, individuals confuse tax exempt and tax deferred. The two are drastically different. Tax exempt means the investment or purchase is completely free of governmental taxation. By contrast, taxes must be paid on tax deferred purchases and investments; the taxes are simply paid at a later date.

An example of a financial product that allows for the postponement of taxes is the tax deferred annuity (TDA). TDAs are often used to help employees save for retirement. With a TDA, an employee may place pre-tax money into a special account. Often, this is done using automatic payroll deduction. Earnings in the account accumulate until the employee is ready to retire. Upon retirement, funds are distributed and taxes are paid.

TDAs not only allow employees to save while making contributions, but they also allow for savings at retirement. In many cases, employees are in a lower tax bracket after retirement. Therefore, the amount of taxes paid after retirement are expected to be lower than those that would have been paid while the employees were still working for a living.

IRAs are popular among tax deferment investments. By investing in an IRA, an individual is able to allow for the accumulation of dividends and interest, as well as appreciation, without paying taxes on the funds. Once the owner of an IRA begins withdrawing funds from the account, he or she is responsible for paying taxes. Generally, IRA owners begin making withdrawals at about 59 and a half years of age.

There are many types of tax deferred investments. Such investments include Employer-Sponsored Qualified Retirement Plans; Roth, traditional, and educational IRAs; annuities; certain types of life insurance; and EE and HH savings bonds. Stocks can be placed in these types of accounts as well.

Nicole Madison
Nicole Madison

Nicole’s thirst for knowledge inspired her to become a wiseGEEK writer, and she focuses primarily on topics such as homeschooling, parenting, health, science, and business. When not writing or spending time with her four children, Nicole enjoys reading, camping, and going to the beach.

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Discussion Comments

Sunny27

Latte31- Good point. I want to add fixed annuities are investment vehicles that also grow tax deferred. With a fixed annuity, you receive a guaranteed rate of return for the first two years and then you are given an interest rate floor which is the lowest possible interest rate you will receive for the term of the annuity.

The problem with fixed annuities is that once you pay into them you are pretty much stuck with them until you retire because there is a tax penalty if you withdraw beforehand.

latte31

Anon30273- I agree it was a great article. I also agree that Traditional IRA’s and 401K accounts are great examples of tax deferred accounts.

The balance of these account grow tax deferred which means that the tax payment is due upon withdrawal which is usually at retirement.

There is a lot of debate as to which accounts are ultimately better- a Traditional IRA, a tax deferred account or a Roth IRA or taxable accounts that allows tax –free withdrawals.

anon30273

This was a great article. It was easy for the average person to understand.

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