The term tax deferred refers to the postponement of paying taxes on earnings until a later date. In an investment situation, money allowed to grow in a tax deferred account is not taxed until it is withdrawn. Some examples of investments on which tax payments are deferred are individual retirement accounts (IRAs), annuities, and certain types of bonds.
Tax-deferred investments can provide investors with valuable savings. Essentially, tax-deferred investments allow investors to save money in the present, dealing with taxes in the future. To take advantage of tax deferred savings, an investor can choose to place pre-tax dollars, up to a certain amount, in various investment products. By doing so, the investor lowers his or her current taxable income and may be able to benefit from taxation at a lower tax bracket.
Sometimes, individuals confuse tax exempt and tax deferred. The two are drastically different. Tax exempt means the investment or purchase is completely free of governmental taxation. By contrast, taxes must be paid on tax deferred purchases and investments; the taxes are simply paid at a later date.
An example of a financial product that allows for the postponement of taxes is the tax deferred annuity (TDA). TDAs are often used to help employees save for retirement. With a TDA, an employee may place pre-tax money into a special account. Often, this is done using automatic payroll deduction. Earnings in the account accumulate until the employee is ready to retire. Upon retirement, funds are distributed and taxes are paid.
TDAs not only allow employees to save while making contributions, but they also allow for savings at retirement. In many cases, employees are in a lower tax bracket after retirement. Therefore, the amount of taxes paid after retirement are expected to be lower than those that would have been paid while the employees were still working for a living.
IRAs are popular among tax deferment investments. By investing in an IRA, an individual is able to allow for the accumulation of dividends and interest, as well as appreciation, without paying taxes on the funds. Once the owner of an IRA begins withdrawing funds from the account, he or she is responsible for paying taxes. Generally, IRA owners begin making withdrawals at about 59 and a half years of age.
There are many types of tax deferred investments. Such investments include Employer-Sponsored Qualified Retirement Plans; Roth, traditional, and educational IRAs; annuities; certain types of life insurance; and EE and HH savings bonds. Stocks can be placed in these types of accounts as well.
