Wealth accumulates faster when the tax liability is deferred. This article will explain how that works and give you some suggestions for tax-deferred investments. Some key points:
- Tax-deferred investments allow you to deposit pre-tax money into accounts that offer tax-free growth. The taxes are paid when you withdraw the money.
- The benefits of tax-deferred accounts include higher compounded growth and potentially lower tax liabilities on withdrawals.
- Annual contribution limits for 401(k), 403(b), 457 plans, and the federal government’s Thrift Savings Plan usually increase annually.
What are tax-deferred investments?
Tax-deferred investments are financial vehicles that allow you to deposit money into them before taxes are taken out.
It’s important not to confuse “tax-deferred” with “tax-free.” The taxes are due when you withdraw the money, typically during retirement when you’re in a lower tax bracket.
This structure enables capital to grow at a faster rate compared to taxable investments. That doesn’t mean your return rate will be higher. Deferring the tax liability leaves more money in the account to accumulate compounded gains.
Take a look at the benefits of tax-deferred investments.
Investing in tax-deferred funds offers some key benefits to individuals and business owners. I’ve listed a few below for your review. Please call my office if you have additional questions.
Compounded Growth
Your full principal can generate returns without an annual tax liability. That allows compounding to work more effectively over time. Gains are typically expressed using a compound annual growth rate (CAGR). The SEC has an online calculator you can use to find yours.
Lower Tax Bracket for Withdrawals
The United States has a progressive tax system that assesses tax rates based on income thresholds. Retirement income is usually lower than working income, so you could be in a lower tax bracket when you withdraw from tax-deferred accounts.
Retirement Security
Contributions to tax-deferred investment funds are usually deducted pre-tax from wages and are essential to retirement plans.
Flexible Contribution Options
Some tax-deferred accounts offer flexibility in how much and when contributions can be made. This is beneficial for small business owners and independent contractors with fluctuating incomes. Traditional IRAs are a good example.
Common Tax-Deferred Investment Options
Tax-deferred investments are a key component of retirement planning. The type of fund you invest in will be determined by your professional circumstances and the amount you have available to set aside for retirement. Here are some of the most common options:
401(k) Plans
401(k) plans are tax-deferred, defined contribution plans. They’re either employer-sponsored or self-managed if you’re an independent contractor. Employees may receive match contributions from their employers, but it’s not required.
Individual Retirement Accounts (IRAs)
There are two types of IRAs. Contributions to traditional IRAs are tax-deferred, while Roth IRA contributions are made with after-tax dollars. Tax-deferred retirement accounts also have required minimum distributions (RMDs) starting at age 73.
SEP IRAs (Simplified Employee Pension IRAs)
Small business owners and self-employed individuals can contribute up to 25% of their net income, up to a limit of $70,000 per year, to an SEP-IRA. Contributions are tax-deductible, and earnings grow tax-deferred.
SIMPLE IRAs (Savings Incentive Match Plan for Employees)
Employers can use SIMPLE IRAs instead of 401(k) or 403(b) plans if they’re willing to contribute a fixed percentage of salaries or match employee contributions. This option is designed for small businesses with up to one hundred employees.
Tax-Deferred Annuities
Annuities are insurance-based investments that provide guaranteed income in retirement. These are popular with high-income earners because there are no annual contribution limits, but withdrawals before age 59½ may be subject to a 10% penalty.
Get familiar with rules, penalties, and other considerations.
It’s important to view the entire picture before investing in tax-deferred funds. They provide significant advantages, but there are rules and guidelines you must follow. Failure to do that could result in penalties and fees. Here are a few examples:
Early Withdrawal Penalties
Tax-deferred retirement funds can be accessed when you reach 59½ years old. Early withdrawals will be penalized 10%. That should only be done when necessary. A low-interest loan might be more cost-effective if you have an emergency need.
Required Minimum Distributions
The IRS will only defer tax liability on retirement savings until age 73. After that, a required minimum distribution will kick in. The amount of these distributions is calculated by dividing the remaining balance by your life expectancy using the IRS life expectancy table.
Contribution Limits
The IRS sets a maximum annual contribution limit for tax-deferred retirement accounts once per year. For 2025, the limit for employees who participate in 401(k), 403(b), 457 plans, and the Thrift Savings Plan is $23,500. The IRA maximum contribution limit is $7,000.
Catch-up Contributions
Individuals over 50 can take advantage of “catch-up contributions” of an additional $7,500 per year for defined contribution plans and an extra $1,000 for IRAs. Some tax-deferred retirement plans are also eligible for a “super catch-up” contribution of up to $11,250 after age 60.
Employer Matching
Employers are not required to match employee contributions, but many do. Maximizing your contributions to meet those of your employees is a great way to build retirement savings faster. However, employer matches do not count towards the IRS annual contribution limits.
Get started with tax-deferred investing today.
Taking advantage of tax-deferred investments can help you build a strong financial foundation for when you reach retirement age. It can also lower your tax liability while you’re working. To explore your investment options and develop a strategy tailored to your needs, schedule a discovery call with us today.
Talk soon,
Jeremy A. Johnson, CPA