Tax-deferred is when you don’t have to pay taxes on a particular account as long as your money remains in it. You wait to pay the tax until you take the money. Once you withdraw your money, it’s up for grabs and the IRS can begin to tax it.
Retirement plans are a great example. Money stashed away in annuities, 401(k)s, and IRAs is tax-deferred to varying degrees and can grow for decades until you reach your retirement age.
A 401(k) is a retirement account that you don’t have to pay taxes on right away (the technical term is “tax-deferred”). These accounts are generally sponsored by employers, who can use them as a substitute for a traditional pension plan. Unlike a pension plan, which is managed and paid for entirely by the employer, a 401(k) acts as a personal retirement plan. Employees can contribute up to 15% of their salary every year (but no more than $11,000 a year for people under 50, and $12,00 for people over 50), which will not be taxed until they withdraw the money.
The interest, investment earnings and employer contributions (the employer can decide to pitch in to the account, if they want) are also not taxed until the employee withdraws the money. If the money is withdrawn before retirement age (currently 59.5 years old), the account holder faces an early withdrawal penalty fee.
If you just started earning your own money recently, don’t you deserve to spend it all? Although you did earn it and certainly can do whatever you want, it may not be the wisest decision to spend every last dime. Lucky for you, there’s an incredibly easy alternative, and it’s called a 401k.
When you participate in a 401k plan, it basically takes money out of your paycheck and puts it into an account for your retirement fund. 401ks are part of a group of retirement plans known as “defined contribution plans,” because the amount that can be contributed to your retirement is defined either by you (the employee) or your boss. A great thing about the 401k is that when a certain percentage is deducted from your paycheck to put into that retirement savings account, it reduces your take-home pay before taxes are calculated. This means that instead of giving a portion of today’s salary away to taxes, you are putting some of it away in a retirement account instead. Then you pay taxes after you retire when your income and tax bracket is lower.
Sounds too good to be true? 401ks are great, but a main drawback is that if you do want to withdraw the money in your retirement account before you are 59.5 years old, you’ll have to pay taxes on it PLUS a 10% penalty fine to the IRS. Although retirement may sound like something in the very distant future for you, it is something to think about, and having a 401k Plan is an effective and pretty effortless way to have a long-term plan.