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.
An annuity is a kind of tax-deferred retirement plan, but it’s usually operated through an insurance company. You pay the insurance company a certain amount of money, and in return that company promises to pay you back with interest over a period of time. An annuity is a simple way to save money for retirement without paying taxes on it right away.
You can pay into your annuity all at once (“lump sum”) or in a series of payments. Depending on your contract, an annuity might start paying you back right away or start at a later date – such as when you plan to retire.
A Keogh plan (named after U.S. Representative Eugene Keogh) is a type of tax-deferred retirement plan specifically for small businesses or people who are self-employed. It allows you to set aside a certain amount from your income before it is taxed, so that you can rack up savings while saving money on your taxes today. Meanwhile, you’re accumulating the cash you’ll need when you stop working in the future.
The plan is tax-deferred, not tax-free, so you will eventually have to pay Uncle Sam when you start withdrawing that money.
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 If the money is withdrawn before retirement age (currently 59.5 years old), the account holder faces an early withdrawal penalty fee.
In certain situations, you can actually put off paying your taxes until later – sometimes many years later – but methods of doing so are pretty complicated. Income whose taxes you can pay later is called tax-deferred, and the most common type of tax-deferred income is the money you put into a retirement plan.
Most retirement plans (IRAs, 401(k)s, Keogh Plans, and so on) allow you to make elective deferrals up to a certain amount. What does this mean? Under a retirement plan, you set aside a portion of your income every year and put it into a retirement account for use – you guessed it – after you retire. Think of it this way: as far as the IRS is concerned, the money you put into a retirement account essentially doesn’t exist until you withdraw it, which means the IRS isn’t going to tax that money until you withdraw it.
But you still have to pay the taxes eventually, right? Why not just pay them now and get it over with? The answer has to do with tax brackets. By the time you actually start using the money in your retirement account, your income may be lower. And if you’re in a lower income tax bracket when you withdraw the money, you’ll pay less in income taxes on that money than you would if you paid up when you originally earned it all those years ago. So in some cases, putting off payment can actually pay off.
A defined contribution plan is a retirement plan in which the company you work or you (sometimes both) put money into the employees plan sometimes at a rate, such as 5% of annual income. That money is generally invested on the employee’s behalf. At the time of the withdrawal, the amount that the employee will receive is not guaranteed because it fluctuates with the investments. An example of a DCP is a 401(k) plan.
Now that Roth IRAs are undergoing a rule change, people at higher income levels can get access to these highly desirable accounts. Read on to learn what the new rules do and don’t allow you to do, as well as how best to convert to a Roth and the pros and cons of doing so.
“If I can take a portion of my assets and shift them over to a Roth, am I going to sleep better knowing they can’t be touched by future tax increases?” – Ben Norquist, president of Convergent Retirement Plan Solutions LLC