The term 'Tax-Deferred' is included in the Investments edition of the Financial Dictionary. Get your copy on Amazon in Kindle, Paperback or Audio edition. Choose your edition here...
Tax deferred money and status pertains to earnings on investments. This includes dividends, interest, and capital gains which are allowed to accumulate without taxes paid until the owner withdraws the earnings and gains. The two most popular kinds of these deferred investments are found in IRAs and tax deferred annuities. Growth that is tax deferred permits gains to be compounded instead of having taxes paid on them.
Investors gain in two different ways from having taxes deferred on their investment returns. The first method is through growth on investments which is tax free. Instead of having to pay taxes on the present returns of the investment, the taxes are not paid until a later time. This allows the investment to increase without setbacks.
The second method from tax deferral pertains to investments which are entered in pre-retirement accumulation phases. At this point, the earnings and taxes on them are generally significantly higher than earnings will be when the owners retire. This means that withdrawals drawn out of deferred accounts typically happen after individuals are bringing in less taxable income. The end result is that their tax rate is at a lower level than the one the IRS applies with they are still working.
There are a number of qualified and approved tax deferred vehicles available today. Probably the most common and popular is the 401(k). Employers provide these plans as a company benefit to help their employees to increase their retirement savings.
Third party administrators act to deduct contributions from employee payrolls and help manage the plans. The employees then get to choose from several options in which to invest their tax deferred savings. These include company stock, mutual funds, or some fixed rate choices. All gains made in these accounts do no add to the taxable earnings of the employees participating. These contributions they make to the 401(k) and other qualified accounts like most IRAs come from pre-taxed dollars. This means that the employee’s taxable income amount becomes reduced.
When the employees surpass the minimum 59.5 retirement age, they are able to take distributions from these plans. The taxes they pay are only those which apply on their earnings as they are received. So investors who may earn enough to pay 33% tax bracket while employed will likely pay as little as 10% to 15% taxes on distributions they take from their 401(k) plans at retirement that they have along with their any other income from interest, social security, or pensions.
401(k)s typically involved employer dollar matching programs that inspire employees to set aside a greater amount of their earnings in order to increase the size of their retirement nest egg. In putting the money off to the future, they will pay fewer taxes in the end.
It is important to understand the difference between tax deferred and non tax deferred retirement vehicles. Some retirement investment accounts are not tax deferred. The owners pay the taxes on the earnings before they contribute them to the accounts. The advantage to this is that all interest, dividends, and capital gains grow without any other taxes being owed on them when they are taken out as distributions at retirement age. One beloved insurance product that works this way is an annuity.
Retirement plans like traditional IRAs have annual contribution limits of $5,500 per year as of 2016. Annuities do not come with such annual restriction levels. Employees can contribute even millions of dollars per year to them if they wish.
The earnings made in these insurance backed products grow without having taxes taken out of them even at retirement. This means that any and all earnings in these account compound fully from the second year of the annuity contract. So long as the gains earned are taken out after the employee reaches 59.5, there will not be any taxes or early withdrawal penalties of 10% levied against the earnings in these pre-taxed contribution accounts.