Tax-Deferred
Tax-deferred means investment growth is not taxed until funds are withdrawn, typically in retirement. Traditional IRAs, 401(k)s, 403(b)s, and annuities offer tax-deferred growth, with contributions often being pre-tax and withdrawals taxed as ordinary income.
Exam Tip
Tax-deferred = taxed LATER as ordinary income (not capital gains). 10% penalty before 59½. RMDs at 73. Examples: Traditional IRA, 401(k), annuities. No step-up in basis at death.
What is Tax-Deferred?
Tax-deferred refers to investment earnings that are not subject to taxes until the money is withdrawn from the account. This allows investments to grow and compound without the drag of annual taxation, potentially resulting in significantly higher account balances over time compared to taxable accounts.
How Tax-Deferred Growth Works
| Stage | Tax Treatment |
|---|---|
| Contribution | Often pre-tax (reduces current taxable income) |
| Growth/Earnings | Not taxed while in the account |
| Withdrawal | Taxed as ordinary income when distributed |
Tax-Deferred Account Types
| Account | Contribution Type | Contribution Limit (2025) | Who Can Contribute |
|---|---|---|---|
| Traditional IRA | Pre-tax (if deductible) | $7,000 (+$1,000 50+) | Individuals with earned income |
| 401(k) | Pre-tax | $23,500 (+$7,500 50+) | Employees of sponsoring employers |
| 403(b) | Pre-tax | $23,500 (+$7,500 50+) | Employees of nonprofits/schools |
| 457(b) | Pre-tax | $23,500 (+$7,500 50+) | Government/nonprofit employees |
| Deferred Annuity | After-tax (non-qualified) | No limit | Anyone |
| SEP IRA | Pre-tax | 25% of compensation (up to $70,000) | Self-employed/small business |
Tax-Deferred vs. Tax-Free Comparison
| Feature | Tax-Deferred | Tax-Free (Roth) |
|---|---|---|
| Tax on Contributions | No (pre-tax) | Yes (after-tax) |
| Tax on Growth | Deferred until withdrawal | Never taxed |
| Tax on Qualified Withdrawals | Ordinary income tax | None |
| Best Tax Scenario | Higher tax bracket now, lower in retirement | Lower tax bracket now, higher in retirement |
| RMDs Required | Yes, at age 73 | No (Roth IRA) |
Benefits of Tax Deferral
| Benefit | Explanation |
|---|---|
| Immediate Tax Savings | Pre-tax contributions reduce current taxable income |
| Compound Growth | Earnings grow faster without annual tax drag |
| Tax Bracket Management | May be in lower bracket when withdrawing in retirement |
| Control Over Timing | Decide when to realize income |
Drawbacks of Tax Deferral
| Drawback | Explanation |
|---|---|
| Ordinary Income Rates | Withdrawals taxed at ordinary income rates (not capital gains) |
| No Step-Up in Basis | Heirs pay income tax on inherited tax-deferred accounts |
| RMDs | Forced withdrawals starting at age 73 |
| Early Withdrawal Penalty | 10% penalty if withdrawn before age 59½ |
| Future Tax Uncertainty | Tax rates may be higher when you withdraw |
Annuities and Tax Deferral
| Annuity Type | Funded With | Tax Treatment |
|---|---|---|
| Qualified Annuity | Pre-tax dollars (IRA, 401(k)) | 100% of withdrawal taxed as ordinary income |
| Non-Qualified Annuity | After-tax dollars | Only earnings taxed; principal returned tax-free |
LIFO Rule for Non-Qualified Annuities: Earnings come out first (taxable), then principal (tax-free).
Early Withdrawal Rules
| Rule | Details |
|---|---|
| Age Requirement | Generally must be 59½ to avoid penalty |
| Penalty | 10% federal penalty + ordinary income tax |
| Exceptions | Death, disability, 72(t) substantially equal payments, first home (IRA), education (IRA) |
Required Minimum Distributions (RMDs)
| Age | Requirement |
|---|---|
| Before 73 | No required withdrawals |
| At 73 | Must begin annual RMDs based on life expectancy |
| Penalty for Missing RMD | 25% of amount not withdrawn (reduced from 50%) |
Tax-Deferred vs. Taxable Account Growth Example
Assume $10,000 invested for 30 years at 7% annual return, 24% tax bracket:
| Account Type | Ending Balance | After-Tax Value |
|---|---|---|
| Tax-Deferred | $76,123 | ~$57,853 (after 24% tax) |
| Taxable | ~$54,000 | ~$54,000 |
| Advantage | +$3,853 | More growth despite taxes on withdrawal |
Exam Alert
Tax-deferred = growth NOT taxed until withdrawal. Contributions are typically pre-tax (reduce current income). ALL withdrawals taxed as ORDINARY INCOME (not capital gains rates). 10% penalty before age 59½. RMDs required at age 73. Examples: Traditional IRA, 401(k), 403(b), 457, deferred annuities. Compare to tax-free (Roth) accounts where qualified withdrawals are not taxed.
Study This Term In
Related Terms
Tax-Advantaged Account
SecuritiesA tax-advantaged account is an investment or savings account that offers special tax benefits, either through tax-deferred growth (Traditional IRA, 401(k)) or tax-free withdrawals (Roth IRA, HSA, 529 plans), designed to encourage saving for retirement, healthcare, or education.
Annuity
InsuranceAn annuity is an insurance contract that provides a stream of income payments, typically for retirement, in exchange for an initial lump sum or series of payments.
Roth IRA
SecuritiesA Roth IRA is a retirement account funded with after-tax dollars that grows tax-free and allows tax-free withdrawals in retirement, with no required minimum distributions.