CandleFocus Glossary Editor
Tax Deferred: Understanding the Basics of Deferring Tax Payments
Taxes are a necessary evil, and tax-deferred status is one way for taxpayers to mitigate the impact of taxation. Tax-deferred status refers to earnings from investments—such as interest, dividends, or capital gains—that accumulate tax-free until the investor takes constructive receipt of the profits. This benefit can be especially beneficial when saving for retirement, as it offers investors the opportunity to enjoy tax-free growth of their investments.
The most common example of a vehicle that offers tax-deferred status is an employer-sponsored retirement plan, such as a 401(k). A 401(k) plan is a qualified defined contribution plan—sponsored by the employer—that allows employees to contribute to their retirement savings with pre-tax income. Employee contributions to the plan are deductible from their income, reducing their taxable income and resulting in an immediate tax reduction. The invested earnings from a 401(k) then accumulate tax-deferred until they are withdrawn at retirement. At that stage, they are taxed as ordinary income.
In addition to 401(k) plans, other options that offer investors tax-deferred status include Traditional IRAs and Roth IRAs. Traditional IRAs involve contributions made with pre-tax dollars, which are then allowed to accumulate tax-deferred until retirement. However, when taking withdrawals from a Traditional IRA during retirement, taxes will be due. By contrast, contributions made to a Roth IRA are made with after-tax dollars. But, when withdrawals are taken during retirement, those investments are entirely tax-free because the contribution has already been taxed.
Tax-deferred status can be a great way for investors to see their retirement savings grow, as the opportunity to earn on earnings—without paying taxes on them until retirement—can be quite substantial. However, it is important for investors to keep in mind that taxes will still be due when funds are taken from such accounts. Tax-deferred status is a great way to defer taxes, but it is not a way to avoid them entirely.
Taxes are a necessary evil, and tax-deferred status is one way for taxpayers to mitigate the impact of taxation. Tax-deferred status refers to earnings from investments—such as interest, dividends, or capital gains—that accumulate tax-free until the investor takes constructive receipt of the profits. This benefit can be especially beneficial when saving for retirement, as it offers investors the opportunity to enjoy tax-free growth of their investments.
The most common example of a vehicle that offers tax-deferred status is an employer-sponsored retirement plan, such as a 401(k). A 401(k) plan is a qualified defined contribution plan—sponsored by the employer—that allows employees to contribute to their retirement savings with pre-tax income. Employee contributions to the plan are deductible from their income, reducing their taxable income and resulting in an immediate tax reduction. The invested earnings from a 401(k) then accumulate tax-deferred until they are withdrawn at retirement. At that stage, they are taxed as ordinary income.
In addition to 401(k) plans, other options that offer investors tax-deferred status include Traditional IRAs and Roth IRAs. Traditional IRAs involve contributions made with pre-tax dollars, which are then allowed to accumulate tax-deferred until retirement. However, when taking withdrawals from a Traditional IRA during retirement, taxes will be due. By contrast, contributions made to a Roth IRA are made with after-tax dollars. But, when withdrawals are taken during retirement, those investments are entirely tax-free because the contribution has already been taxed.
Tax-deferred status can be a great way for investors to see their retirement savings grow, as the opportunity to earn on earnings—without paying taxes on them until retirement—can be quite substantial. However, it is important for investors to keep in mind that taxes will still be due when funds are taken from such accounts. Tax-deferred status is a great way to defer taxes, but it is not a way to avoid them entirely.