What Does Tax-Deferred Mean?
When it comes to retirement accounts, tax-deferred accounts are mentioned a lot. Knowing what tax-deferred means will help you decide if these accounts are right for you.
Saving for retirement can come with a learning curve. After all, most of us aren’t taught the basics of investing, retirement savings, and other valuable financial information. When it comes to different retirement account options, there are essential things to consider. Things like employer-sponsored accounts, IRAs vs. 401(k)s, rolling over old 401(k)s, and the endless options to invest in are all necessary for choosing the right vehicle to save for retirement. However, one term that gets circulated within retirement accounts is tax-deferred.
Tax-deferred refers to retirement accounts that delay the tax obligation of the account holder. Instead of paying taxes first and then depositing funds into a retirement account, a tax-deferred account contributes pre-tax dollars. Taxes are then applied when the funds are distributed during retirement. This allows participants to contribute more during their working years, thus receiving more compounding growth.
What are retirement accounts tax-deferred?
Not all retirement accounts are equal. The IRS sets different guidelines for retirement accounts depending on whether they are tax-deferred or not or whether they are employer-sponsored or individual accounts.
When it comes to tax-deferred retirement accounts, none are more popular than the 401(k). Provided by employers to their employees, a 401(k) is one the easiest ways to save for retirement. Many companies auto-enroll their new hires, and contributions are made to the account without the employee ever seeing the money. Even better, many employers offer to match employees’ contributions up to a certain percent. The typical employer match is 3% of the employee’s salary.
Another common tax-deferred retirement account is a traditional IRA. IRAs are provided by many institutional investment brokers like Vanguard and Fidelity. Usually, IRA account holders get paid and pay taxes first, then contribute to a tax-deferred IRA. These contributions become tax credits that offset the individual’s tax obligation for that tax year.
These tax-deferred retirement accounts are great options for those who plan to save a lot and maximize their retirement savings. This, in turn, allows the account to grow even more as more money is being contributed without taxes being taken out first.
What retirement accounts are not tax-deferred?
On the other hand, non-tax-deferred retirement accounts are contributed with after-tax dollars. Meaning, when the person gets paid, taxes are first taken out of their paycheck before putting money away into these accounts. However, those contributions and their growth are then distributed during retirement tax-free.
Employer-sponsored retirement plans can provide non-tax-deferred accounts called Roth 401(k)s. These work in similar ways to traditional 401(k)s; however, contributions are made after taxes are taken out of the income. The plan’s administrator then automatically contributes the funds into the Roth 401(k) without the employee ever touching the money. Employers can even match the contributions employees make towards a Roth 401(k); however, the employer’s matching contributions are tax beforehand. So the employer’s match goes into a traditional 401(k) and is tax-deferred until retirement.
Another popular non-tax-deferred retirement account is the Roth IRA. Like traditional IRAs, Roth IRAs are held at outside brokerages. Participants receive their paychecks with taxes taken out, and they contribute however much of the leftover amount they want to their Roth IRA. The IRS limits Roth IRAs to $6,000 of annual contributions.
What are the advantages of tax-deferred retirement accounts?
Tax-deferred retirement accounts have many inherent benefits. However, what may be benefits to some may not be that important to others. So be sure to get familiar with these and weigh what is most important.
First, because the tax obligation is delayed until retirement, it lowers your tax responsibility during your working years. Chances are you’re in a higher tax while you’re working than you’ll be during retirement. So by lowering your net income while you’re still working, it may reduce how much you’ll owe in taxes each year.
Secondly, since Uncle Sam isn’t reaching his hand into your paycheck before you contribute to your tax-deferred account, you’re able to contribute a lot more each paycheck. If you earned $100,000 in 2021, you’d fall into the 24% tax bracket. If you contributed 10% of your income in a tax-deferred retirement account, you’d be saving $10,000 a year towards retirement. However, if taxes were taken out first, you’d only be contributing about $7,600 annually.
What are the disadvantages of tax-deferred retirement accounts?
While no one should ever avoid saving for retirement altogether, weighing the disadvantages of certain retirement accounts can help you choose the best type of retirement account for you. That being said, the disadvantages of tax-deferred accounts may not be disadvantages or mean that much to you.
One of the main disadvantages to tax-deferred retirement accounts is the inability to know what tax bracket you’ll be in during retirement. For those that are just starting their careers in their 20’s, it’ll be another 40 or so years before they retire. Federal and state policies are sure to change during that time and could be increased significantly. Additionally, inflation could diminish the value of the money you put in years ago—however if appropriately invested, your gains should out-pace inflation.
Another disadvantage is when you’re in retirement, you may need to rely on more income to facilitate assisted living and health expenses. Having to pay taxes—possibly at a higher tax bracket—during retirement can eat into the amount of money you have to live off of. At the very least, because taxes will be due on your distributions, it is wise to consult a tax professional to make sure you’re distributing enough to meet your needs and the IRS’s required minimum distribution guidelines.