Definition
Tax deferral refers to instances where a taxpayer can delay paying taxes to some future period. In theory, the net taxes paid should be the same. Taxes can sometimes be deferred indefinitely, or may be taxed at a lower rate in the future, particularly for deferral of income taxes. It is a general fact of taxation that when taxpayers can choose when to pay taxes, the total amount paid in tax will likely be lower.
Tax Deferred
What is ‘Tax Deferred’
Tax-deferred status refers to investment earnings such as interest, dividends or capital gains that accumulate tax free until the investor takes constructive receipt of the gains. The most common types of tax-deferred investments include those in individual retirement accounts (IRAs) and deferred annuities. Tax deferral allows growth to be compounded on the portion of earnings not forsaken to investment taxation. Next Up Tax-Deferred Savings Plan Qualifying Investment Deferred Annuity Deferred Account
Explaining ‘Tax Deferred’
By deferring taxes on the returns of an investment, the investor benefits in two ways. The first is tax-free growth. Rather than paying tax on the current returns of an investment, tax is paid only at a later date, leaving the investment to grow unhindered. The second benefit of tax deferral extends to investments made during pre-retirement periods when earnings and taxes levied against working wages are typically higher than earnings in post-retirement phases. Withdrawals taken from tax-deferred investment accounts occur when a person is earning less taxable income and the tax rate realized by an individual is usually lower than the rate applied during the employment phase.
Qualified Tax-Deferred Vehicles
A 401(k) plan is a common vehicle offered by employers to grow employees’ retirement savings. Companies utilize a third-party administrator to manage contributions deducted from employee earnings. Employees choose to invest savings among various options: mutual funds, company stock or fixed-rate options. Gains attributed to securities held within the 401(k) do not apply to the employee’s taxable income. Contributions to qualified savings plans such as 401(k) accounts are made on a pre-tax basis, reducing taxable income received by the employee.
Nonqualified Tax-Deferred Vehicles
A nonqualified tax-deferred investment does not reduce taxable income but allows capital gains and interest to grow unencumbered. Annuities are a popular insurance product embracing the benefits of tax deferral. While qualified retirement plans such as traditional IRAs limit contribution amounts to $5,500 annually, many annuities do not restrict contribution amounts. A $1 million fixed annuity contribution with a guaranteed 2% interest rate backed by an insurance company allows earnings to accumulate without being taxed by the Internal Revenue Service (IRS). The $20,000 in interest grows without the IRS levying taxes against the earnings, allowing the full amount to compound in the second year of the annuity contract. A money market investor in a 33% tax bracket, realizing the same interest rate, would owe $6,666 in tax to the IRS as earnings are treated as ordinary income. Interest received after age 59.5 avoids an IRS penalty for early withdrawal, which is a 10% assessment against interest earned.
Further Reading
- The tradeoff between mortgage prepayments and tax-deferred retirement savings – www.sciencedirect.com [PDF]
- Asset allocation and asset location: Household evidence from the Survey of Consumer Finances – www.sciencedirect.com [PDF]
- Avoiding taxes at any cost: The economics of tax-deferred real estate exchanges – link.springer.com [PDF]
- Household portfolio choices in taxable and tax-deferred accounts: another puzzle? – academic.oup.com [PDF]
- Executive compensation, taxes, and incentives – books.google.com [PDF]
- Taxable and tax-deferred investing: a tax-arbitrage approach – academic.oup.com [PDF]
- Japan's financial crisis and economic stagnation – www.aeaweb.org [PDF]
- Optimal savings with taxable and tax-deferred accounts – www.sciencedirect.com [PDF]
- Tax-motivated trading by individual investors – www.aeaweb.org [PDF]
