Tax-deferred describes a type of investment account which features a temporary break from investment taxes.
The U.S. government confers the status of tax-deferred on specific long-term investment accounts that serve a social good, such as retirement or education.
In a tax-deferred account, taxes are collected on income withdrawn later rather than on investment activity during the life of the account or, in the case of certain accounts, not at all.
Do you have a 401(k) plan, a 529 College Savings Plan, or an Individual Retirement Arrangement (IRA) account? If so, you are investing in a tax-deferred account.
Tax-deferred accounts are usually going to be long-term savings vehicles. They are typically used for investments that have a longer time horizon before commencing (like retirement) or a predetermined need date (like college savings plans).
Investors place money into a tax-deferred account with the hopes that over time they will grow. An investor is not charged taxes year to year on the amount of that growth.
For example, let’s say an investor placed $5,000 into a tax deferred account and invests it into Investment A. In one year’s time, Investment A grows by 5% to $5,250.
If the investor decides to sell Investment A, and within the tax-deferred account, switches to Investment B, no taxes are due.
If an investor did the same thing in a taxable (non-deferred) account, the investor likely would owe capital gains taxes in that tax year.
Granted, this would be at a lower rate if the investment is held longer than a year, but it’s taxable nonetheless.
Don’t confuse a tax-deferred account with how the proceeds are distributed at a later date. We are simply looking at the interim period for tax deferral, between the time invested and the time distributed.
For example, 100% of the distribution from a traditional 401(k) or IRA is taxable at the time taken (retirement, for example). Proceeds from a Roth IRA are distributed on a tax-free basis, since the contributions were previously taxed as income.
Judicious use of tax-deferred accounts can greatly increase one’s retirement balance while cutting taxes on income today.
Later in retirement, presumably, your income will be lower and thus the distributions taken for living expenses also would be taxed at lower rates than otherwise.
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