What is a tax-deferred investment?
With a tax-deferred investment, you pay federal income taxes when you withdraw money from your investment, instead of paying taxes up front. Any earnings your contributions produce while invested are also tax deferred.
Some investments also allow you to invest pre-tax dollars, so neither your contribution nor its potential earnings are taxed until they are withdrawn.
How does a tax-deferred investment work?
First, because your money is reinvested and no money is taken out for taxes, you have potentially more money to compound and grow. That means when you withdraw the funds, your investment may be larger than a similar investment that is subject to capital gains tax each year.
Second, if you're investing for retirement, you may be in a lower tax bracket when you withdraw the money than you are now.
Because tax-deferred investments are generally designed to help you invest for specific long-term goals (such as retirement or a child’s education), there are restrictions on when the money can be withdrawn without penalty. Early withdrawals may be subject to sales charges and fees. Withdrawals prior to age 59½ may be subject to a 10% income tax penalty.
What types of tax-deferred investments are available?
- Employer-sponsored retirement plans. An employer-sponsored plan, such as a 401(k), 403(b) or 457, typically allows both pre-tax contributions and tax-deferred compounding. Also, many employers offer a matching contribution.
- Individual Retirement Accounts (IRAs) – Traditional and Roth. Traditional IRAs may allow you to contribute on a pre-tax basis, depending on your income level and some other factors. With a Roth IRA, you can’t make pre-tax contributions, but earnings could potentially be tax-free if certain conditions are met.
- Annuities. An annuity is a contract between you and your life insurance company. It provides death benefits and may also include other guarantees. Death benefits may help protect your beneficiaries if you die before the annuity’s proceeds have been distributed. Annuities do have limitations, and guarantees are subject to the claims-paying ability of the issuing insurance company.
Carefully consider your current and anticipated personal financial circumstances as well as changes in tax rates and tax treatment of investment earnings when making investment decisions.