Tax-deferred: What does it mean and how does it benefit you?

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When it comes to investing, it’s critical to consider how taxes might impact your earnings. Luckily, some tax-efficient investment strategies allow your money to grow and compound without the immediate drag of taxes.

Some of the best retirement plans, including traditional IRAs and traditional 401(k)s, are tax-deferred. These accounts are considered an ideal place to park long-term investments, since you can escape paying taxes on realized gains for decades.

Here are key tax-deferred accounts available and how you can start investing in them.

Tax-deferred: What does it mean?

Since the introduction of the Individual Retirement Account (IRA) in 1974, the U.S. government has passed legislation letting individuals contribute to tax-advantaged accounts. These accounts motivate people to save for their retirement, so they aren’t solely reliant on government-funded programs such as Social Security.

In essence, contributions to tax-deferred accounts such as a traditional IRA or traditional 401(k) allow you to postpone paying taxes until you begin making withdrawals. At that point, the government taxes your earnings as ordinary income.

Tax-deferred accounts have two main advantages over typical taxable accounts:

• First, they lower your annual taxable income when you contribute to them. When you add money to a tax-deferred account such as a traditional 401(k), it may come out of pre-tax income, reducing your taxable income for the year.
• Second, you won’t owe taxes on your investment gains until you begin withdrawing the funds. If you realized a capital gain in a taxable account, you’d owe tax on it. And if you receive a dividend, then that’s taxable, too. (But there are other benefits, too.)

That’s why most financial professionals encourage investors to max out their contributions to tax-deferred accounts, especially if you are in a high tax bracket and expect to pay lower taxes in the future.

Types of tax-deferred investment accounts

Several types of investment accounts offer tax-deferred benefits to holders, each with their own benefits and eligibility criteria. Here are a few examples:

Through tax-deferred accounts such as an IRA or a 401(k), you can invest in stocks, exchange-traded funds (ETFs), mutual funds, bonds, certificates of deposit (CDs) and other assets. With potentially high-return investments such as stocks and stock funds, you can defer tax on enormous gains for years.

But even taxable investment accounts offer the ability to defer a capital gain as long as you don’t realize the gain by selling the investment. In fact, in some cases if your taxable income is low enough you can avoid capital gains taxes altogether.

What are the drawbacks of investing in tax-deferred accounts?

To enjoy the benefits of a tax-deferred account, the account holder must abide by various rules and restrictions.

A few of these rules include:

• Contribution caps: Each year, the IRS establishes limits on how much you can save in tax-deferred accounts. The maximum contribution to a 401(k) plan in 2024 is $23,000, while the limit for IRA contributions is $7,000. Those 50 and over can contribute an additional $7,500 each year to a 401(k) and an extra $1,000 to an IRA.
• Penalties on early withdrawals: Taking money early from tax-deferred accounts comes at a cost. The IRS will hit you with a 10 percent penalty if you withdraw funds from your 401(k) plan or IRA before age 59½. You’ll also owe taxes on the amount withdrawn, since you didn’t pay taxes on the income when it went into your account. Although you may be able to take early withdrawals in some circumstances, it’s usually not a good idea to touch your savings in these accounts.
• Required withdrawals: Even though your money has grown tax-free, you will have to pay taxes on it eventually. This is the case for retirement accounts like an IRA or 401(k), which have required minimum distributions (RMD) starting at the age of 73. Missing or skipping an RMD can result in significant tax penalties.

Consulting with an investment advisor or tax professional is important to ensure you’re making the best decision for your financial situation and goals.

Bottom line

While the terms and conditions for tax-deferred accounts can be complex, the benefits can be substantial. By strategically using these accounts, you can optimize your wealth-building potential, allowing your investments to compound over time. Working with an expert advisor can help you make the most of these accounts, and Bankrate’s financial advisor matching tool can connect you to qualified professionals in minutes.