Nearly half of American households have less than $100,000 saved for retirement, according to a recent Statista survey. At the same time, figuring out how to build a solid financial future is tough as it is. So when you throw taxes into the mix, it gets even more confusing. Fortunately, you can opt for a tax-deferred investment to secure your future.
This article explains how it works and the different types of accounts that offer this option. You’ll see the good and the not-so-good to weigh what fits your plans.
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What Is a Tax-Deferred Investment?
A tax-deferred investment lets your money grow without paying taxes on the gains each year. Instead, you pay taxes later when you take the money out, usually during retirement.
This kind of setup is ideal for long-term investments like retirement because it gives your savings more time to grow. You don’t lose part of your returns to yearly taxes, which can make a difference over time.
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Benefits of Tax-Deferred Investment
Putting money into a tax-deferred account can help you make the most of your savings in the following ways:
It Can Lower Your Tax Bills
If you’ve ever looked at your paycheck and felt like too much went to taxes, you’re not alone. One benefit of putting money into a tax-deferred account is that it can help lower what you owe the IRS for the year.
For example, let’s say you earn $60,000 and decide to put $6,000 into a traditional IRA. That $6,000 won’t be counted as part of your taxable income. Now you’re only taxed on $54,000 instead of the full amount. That can shrink your tax bill and possibly keep you in a lower bracket.
This can be especially helpful if you’re trying to save or invest.. It’s one way to keep more of your money working for you now while still planning for later.
It Can Increase the Potential for Compounding
When you don’t pay taxes on your earnings every year, your money can grow faster. That’s because the full amount stays in your account and keeps building.
Let’s say you put in $5,000 and it grows by 7%. That gives you $5,350. If you’re not taxed on that growth, you now have more money working for you the next year. Then that amount grows again, and it keeps going from there.
The longer you leave it alone, the more it can build on itself. Over time, that can make a big difference.
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Drawbacks of Tax-Deferred Investment
Tax-deferred accounts come with some solid benefits, but they aren’t perfect. There are rules to follow, limits on how much you can add, and penalties if you take money out too soon.
Caps On Contributions
Tax-deferred accounts come with limits on how much you can put in each year. The IRS sets these limits and can change from year to year.
If you earn more, you might find these limits make it harder to save as much as you’d like in one account. And if you go over the limit by mistake, you could face a penalty. It’s important to keep track of how much you add so you don’t run into issues later.
Early Withdrawal Penalties
If you take money out of your tax-deferred account way too early, there’s usually a 10% penalty. So if you pull out $10,000 early, you might lose $1,000 right off the top, not including the regular taxes you still owe.
Let’s say you lose your job or face a medical bill you didn’t plan for. You might think about using your retirement savings to get through it. But once you factor in the penalty and taxes, you might end up with less than you expected.
While this rule can feel frustrating, it does help keep your savings on track. It gives you one more reason to leave the money alone and let it grow for later.
Required Withdrawals
Once you turn a specific age, you’re required to start taking money out of most tax-deferred accounts. These withdrawals are called Required Minimum Distributions, or RMDs.
Suppose you have money in a traditional IRA or 401(k). Even if you don’t need the cash right away, the rules say you still have to start pulling some out each year. If you skip it or don’t take enough, you could face a steep penalty from the IRS.
This rule means you can’t keep your money in the account forever to avoid taxes. It’s something to keep in mind as you plan ahead, especially if you’re hoping to stretch your savings over a longer period.
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Types of Tax-Deferred Investment Accounts
There’s more than one way to grow your money while putting off taxes. Some options are offered through work, while others you can open on your own. Each one works a little differently, but they all help you save more and pay taxes later.
Individual Retirement Accounts (IRAs)
A traditional IRA lets you set money aside before taxes are taken out. That means you can lower your taxable income now and let your savings grow over time without paying taxes each year on the earnings.
You don’t need to have a certain type of job or work for a specific employer to open one. As long as you have earned income, you can usually contribute.
There are yearly limits, and those can depend on how much you make and how you file your taxes. Still, it’s a simple option to start saving for the future on your own terms.
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Employer-Sponsored Retirement Plans
Many workplaces offer retirement plans that help you save automatically. Your employer sets up these plans, which they will fund through payroll deductions, so the money comes straight out of your paycheck.
Traditional 401(k)
If your job offers a 401(k), it can be one of the easiest ways to start saving for retirement. The money comes straight out of your paycheck before taxes, which helps lower your taxable income right away. Many employers also match part of what you put in, which means free money added to your savings.
Let’s say you earn $60,000 a year and decide to put 10% into your 401(k). That’s $6,000 going into your account automatically. Then, if your employer matches even a small part of that, your savings grow faster without much extra effort from you.
You don’t pay taxes on your 401(k) savings until you take the money out later, usually after you stop working. That gives your balance more time to grow while you focus on other goals.
Traditional 403(b)
If you work for a school, hospital, church, or nonprofit, you might have access to a 403(b) plan. You can contribute money from your paycheck before taxes are taken out, which lowers your taxable income now and helps your savings grow over time.
For example, if you earn $50,000 a year and choose to put $5,000 into your 403(b), that money gets invested and grows without you having to pay taxes on it each year. You’ll pay taxes later when you take the money out, usually after you retire.
Annuities
An annuity is a contract you make with an insurance company. You put in money, and later on, you get payments back, usually during retirement. The money grows without being taxed each year, and you only pay taxes when you start receiving payments.
Fixed Deferred Annuity
A fixed deferred annuity gives you a set rate of return for a certain number of years. It’s a slower way to grow your money, but it’s steady and comes with less risk.
For example, if you put in $10,000, the insurance company might promise to grow it by 3% each year for the next five years. During that time, you won’t pay taxes on the interest. You’ll only pay taxes when you start taking the money out later.
This kind of plan can work well if you want predictable growth without the ups and downs of the stock market.
Variable Annuity
A variable annuity lets you invest in things like stocks and bonds inside the annuity. How much your money grows depends on how those investments perform. You have a chance to earn more, but there’s also more risk.
Let’s say you put in $20,000 and choose investments that do well. Your balance could grow faster than a fixed option. But if the market drops, your balance might shrink for a while too.
The good part is you don’t pay taxes on the gains each year. You pay later when you start taking money out. This setup gives you more control, but it also takes more patience and a higher comfort level with ups and downs.
Stocks
When you invest in stocks through a tax-deferred account like a traditional IRA, you don’t have to pay taxes on your gains each year. You only pay when you sell the stock or take money out of the account.
For example, let’s say you buy shares of a company for $3,000 and they grow to $5,000 over time. Inside a tax-deferred account, you won’t owe anything on that $2,000 gain until you withdraw the money. This helps your full balance keep growing without yearly tax cuts.
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Savings Bonds
Savings bonds are a slow and steady way to grow your money. You don’t pay taxes on the interest each year. Instead, you wait until you cash them in.
For example, if you buy a U.S. Series EE or I Bond, the interest it earns can keep building over time without being taxed along the way. When you redeem it, that’s when you report the interest and pay taxes on it.
These bonds are often used if you want a low-risk option. They won’t grow fast, but they’re simple, reliable, and can be part of a longer-term plan.
Pick a Tax-Deferred Investment Plan That Supports Your Financial Targets
Choosing the right plan starts with knowing where you stand. Think about your current income, how long you plan to keep the money invested, and when you’ll need to use it. Some accounts let you save more, while others offer more flexibility when it’s time to withdraw.
Also, it can help to mix different types of accounts so you’re not relying on just one approach. And if you’re not sure what fits your situation best, talking to a financial advisor can bring more clarity.
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