Tax-deferred accounts were created to incentivize saving for retirement. 401(k)s and Individual Retirement Accounts, or IRAs, are two common types of tax-deferred accounts.
What is a tax-deferred account?
A tax-deferred account is one in which you defer paying taxes until a later date. These accounts are meant to be vehicles for retirement savings.
Tax-deferred vs. tax-exempt accounts
“Tax-deferred” and “tax-exempt” may be used interchangeably to describe retirement accounts, but the two terms mean very different things. The difference comes down to when you pay taxes on your contributions.
With a tax-deferred account such as a 401(k), your tax savings apply when you contribute, while with a tax-exempt account such as a Roth IRA, your savings show up when you make withdrawals.
Benefits and restrictions of tax-deferred accounts
Tax-deferred accounts have two primary benefits:
- If you qualify for and choose to contribute to a 401(k) plan, you can defer paying income tax on the money you contribute to the plan. Instead, you’d pay taxes on the money when you withdraw it, as long as you withdraw it after age 59 ½.
- When you invest in a tax-deferred account, you won’t pay taxes on the profits until you withdraw. Note, however, there is still a level of risk, as the investment could stagnate or lose value over time.
That said, these accounts also have some restrictions:
- You can’t withdraw money from these accounts until age 59 1/2 without paying a penalty of 10% plus income taxes.
- There are also limits on how much and how little you can contribute to these accounts, depending on your income, marital, and employment status.
- You have to start withdrawing money at age 72 from some accounts, even if you don’t need the money yet.
3 types of tax-deferred accounts
1. Employer-sponsored retirement plans
Two of the most common employer-sponsored retirement accounts are the 401(k) and the 403(b).
A 401(k) is typically offered through your employer. An employee designates a certain percentage of their salary to flow directly into that account before any taxes are paid on that money.
Some employers also choose to contribute to employee 401(k) plans. The employer may match contributions dollar-for-dollar up to a certain amount or percentage of your salary, or contribute 50 cents on top of every dollar you contribute. You may need to contribute a certain amount to your 401(k) each month for your employer to match your contributions.
Generally, there are no minimum contributions needed to maintain a 401(k). The maximum you can contribute annually is $19,500, as of 2021. If you are older than 50, you can contribute an extra $6,500 in “catch-up” contributions.
Generally, you can’t access these funds until age 59 1/2. If you do withdraw early, you pay a 10% penalty and income taxes. There are a few exceptions, such as total and permanent disability.
A 403(b) works much like a 401(k). Both employers and employees can contribute pre-tax money into the account. However, 403(b) accounts are only accessible to certain kinds of employees. They’re designed for people who work for tax-exempt organizations such as charities, religious groups, or public schools.
You must contribute at least $200 a year from your salary to qualify for a 403(b), according to the IRS.
2. Individual Retirement Accounts (IRA)
An IRA is a type of tax-deferred account that isn't tied to an employer. You can set up an IRA with a bank, a life insurance company, or a brokerage.
There are two types of IRAs: Traditional IRAs and Roth IRAs. The former is tax-deferred, while the other is tax-exempt.
With a traditional IRA, you put pretax money into a retirement account. You pay income taxes on withdrawals later. How much income tax you pay depends on your tax rate when you withdraw the money after age 59 ½.
With a traditional IRA, you can contribute as much as $6,000 a year, as of 2021. That amount goes up to $7,000 if you are 50 or older.
However, these contributions are not always tax-deductible. The tax deduction is reduced or eliminated if you or your spouse also have a 401(k) plan at work, or if you reach a certain income threshold.
A Roth IRA is a retirement savings account that lets you contribute money after you’ve paid tax on it, not before. That is, you pay income tax on contributions when they’re made, not when they’re withdrawn in retirement.
The maximum amount you can contribute to a Roth IRA is also $6,000 a year, and $7,000 for those 50 and older, as of 2021. However, if you file as an individual and have an adjusted gross income of more than $125,000 but less than $140,000, the amount you can contribute is reduced, as of 2021.
An annuity is a contract between you and an insurer or a financial institution. You pay a lump sum upfront or make monthly payments, and the annuity provider invests the money and pays you back when you retire.
In your contract, you decide how you want your money invested–in stocks, bonds, exchange-traded funds, or other investment vehicles–and when you want to start collecting repayments. You can also choose to receive the money in lump sums or in regular monthly payments. Those payments continue over a period of time or until you die.
The period when you’re paying into an annuity is called the accumulation phase. The date when you start to receive payments is called the payout phase. You have no tax obligation on an annuity until the payout phase, or when you take a lump sum. Then, it’s taxed at your regular income tax rate.
The importance of tax-deferred accounts
Tax-deferred accounts offer two major benefits: They can lower the amount of taxes you pay in the present and allow you to invest pre-tax money for retirement. While there are no truly tax-free retirement accounts, investing pre-tax dollars for retirement and deferring taxes until you withdraw is one strategy for saving for the future.