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.
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.