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What Is a Tax-Deferred Savings Plan?

Tax is a compulsory contribution or payment to the government. Governments around the world collect different types of taxes on income, investments, properties, goods and services, and others. This money is meant for the development of the country. Governments may build flyovers, stadiums, and monuments or use them for healthcare, education, defense, etc. 

Tax is one of the most important considerations in personal finance. It can impact your investment returns, income, and, consequently, lifestyle. Every penny you earn can be subjected to income tax. Likewise, the money that your investments fetch you is also taxed. While tax is obligatory and tax evasion is a crime, there are some ways to lower your tax output. You can use strategies like tax loss harvesting, charity, lifetime gift exemption, and more to reduce your tax liabilities and save money. Consult with a professional financial advisor who can advise on how to minimize your taxability using tax-saving strategies.

Additionally, you can also use tax-deferred plans. These plans do not remove tax from the picture entirely. But they help you delay the payment to the future when you may have a lower income and can therefore get away with a lower tax cut. 

There are several types of tax-deferred pension and retirement savings plans. Keep reading to know about them and how deferring tax can be helpful for your financial growth. 

What are tax deferred plans?

A tax-deferred retirement plan is a type of retirement account that defers or postpones your tax liabilities until after retirement. You do not owe any tax on your money until it is withdrawn, which is most likely in retirement or after a certain age. The primary purpose of using this retirement account is to delay your cash outflow to a later stage in life. Using a tax-deferred retirement plan can be particularly helpful if you foresee yourself being in a higher tax bracket in the future. This way, you get to save money in the present and soften the blow of tax when you are older. 

It is important to note that a tax-deferred plan is different from a tax-exempt account. The former is used to delay the payment of taxes. When you use them, you get a tax deduction on your contributions made in the present. On the other hand, a tax-exempt account offers you tax-free withdrawals in the future. Your contributions do not qualify for any tax deduction and are made with after-tax dollars. 

What is the purpose of tax-deferred retirement accounts?

There are several reasons to use a tax-deferred retirement plan. Here are some of them:

1. Low taxes in the present:

The U.S. tax bracket percentages can range between 10%, 12%, 22%, 24%, 35%, and 37%. Your individual tax rate is decided on the basis of your income and filing status. The higher the tax bracket, the more money you would have to shell out in taxes. Therefore, deferring your tax by using the right investment plan can be an effective strategy to save money. 

2. Enjoy a lower tax cut in retirement:

Most retirees rely on their 401k returns, Social Security benefits, pension, etc., for their retirement expenses. These sources of income may hardly compete with a salary from a job or business income. In most cases, the retirement income is lower than the pre-retirement income. Therefore, the tax rate is also lower, and you pay less. 

3. Higher investments:

Saving up on taxes offers you more financial liquidity. If you are mindful of your savings and use them wisely, you can invest more money into your tax-deferred accounts or other investment options. A higher contribution, along with compounding, results in a higher return at maturity. Therefore, you get to earn a bigger reward in the end.

4. Consistency: 

Other than the obvious benefit of tax savings, a tax-deferred retirement plan also helps you be financially disciplined. Most of these accounts have annual contribution limits. Maximizing those can help you build a large retirement corpus. They may also have withdrawal rules and penalties on early withdrawal that force you to stay invested for the long run and, in return, earn a higher profit. 

Types of tax-deferred pension and retirement savings plans

If you want to postpone your tax to the future, you can choose any of the following options:

1. Traditional 401k: 

A 401k is a tax-advantaged retirement plan that can be categorized into Roth and traditional. The former is a tax-exempt account, and the latter is a tax-deferred account. A traditional 401k is a company-sponsored plan that an employer or organization may offer to its employees. While it is not mandatory for employers to provide their employees a 401k, most companies do so to ensure better employee retention, work satisfaction, and improved productivity. In a traditional 401k, you can contribute your pre-tax dollars, and your withdrawals are taxed in retirement. Since traditional 401ks help you push your tax liability to the future, they have Required Minimum Distributions (RMDs) from the age of 72. You must make these compulsory withdrawals from your account to avoid a 10% penalty by the Internal Revenue Service (IRS). In addition to this, traditional 401ks also have withdrawal rules. For instance, you can only make penalty-free withdrawals after the age of 59.5. Premature withdrawals attract a 10% penalty. However, there are some exceptions to this rule, such as if you suffer from permanent and total disability.

As of 2022, the contribution limit for a 401k is as below:

  • People below the age of 50 can contribute $20,500 per year.
  • People aged 50 or more can make a catch-up contribution of $6,500 per year and contribute $27,000 in total.
  • The contributions cannot exceed $61,000 per year for people under 50 and $67,500 for those aged 50 or older.

2. Traditional Individual Retirement Account (IRA):

A traditional IRA is another tax-deferred retirement planHowever, it is not offered by companies. Instead, you can open it yourself with a financial institution. Anyone with an earned income can contribute to a traditional IRA. Banks, credit unions, brokers as well as insurance providers offer IRAs. Just like the 401k, an IRA also has annual limits set by the IRS. Moreover, the IRA also has two variants – the traditional and the Roth. The latter is a tax-exempt account. Non-qualified withdrawals from a traditional IRA before the age of 59.5 are subject to income tax and a 10% penalty. A traditional IRA also has RMDs from the age of 72 and a 10% penalty if you do not make a distribution on time.

As of 2022, the contribution limit for an IRA is as below:

  • People below the age of 50 can contribute up to $6,000 per year.
  • People aged 50 and above can make a catch-up contribution of $1000 per year and contribute $7,000 in total.

3. 403(b) plan:

A 403(b) plan is another tax-deferred retirement plan similar to the 401k. It is also known as the tax-sheltered annuity or a TSA plan. The primary difference between a 401k and a 403(b) account is that the latter is offered by public schools and some Code Section 501(c) (3) tax-exempt organizations. These can include qualified religious organizations like churches, charitable organizations, and other similar entities. Employees of non-profit organizations and government firms, such as nurses, teachers, professors, government employees, etc., may be offered a 403(b) account for retirement savings. A 403(b) plan also offers the traditional and the Roth versions.   

As of 2022, the contribution limit for a 403(b) plan is as below:

  • People below the age of 50 can contribute $20,500 per year.
  • People aged 50 or more can make a catch-up contribution of $6,500 per year and contribute $27,000 in total.  
  • The contributions cannot exceed $61,000 per year or 100% of the employee's latest yearly salary.

4. Tax-deferred annuities:

Annuities are a popular retirement tool that helps you create a source of steady income in retirement. You can buy an annuity from an insurance provider. You can invest in an annuity plan over time or purchase it in a lump sum. This is known as the accumulation phase. The insurer will give you the compounded funds as a regular income throughout retirement or in a lump sum when you retire. This is known as the payout phase. Annuities are tax-deferred pensions and retirement savings plansThis means you only pay tax when you withdraw your funds in retirement.

Meanwhile, your contributions are tax-deferred. All withdrawals are taxed as per your tax slab for the year. So, the way you withdraw your money can impact your tax liability. A lump sum withdrawal can put you in a higher tax bracket and therefore force you to pay more. On the other hand, regular income may not add too much to your tax liabilities. So, make an informed choice. Annuity plans also have a 10% penalty and income tax on withdrawals made before the age of 59.5. 

Since an annuity plan is primarily an insurance product, it includes a death benefit that protects your loved ones in the case of your demise.

5. IRC 457(b) Plan

An IRC 457(b) plan is a non-qualified, tax-deferred plan offered to some state and local government entities. Only organizations defined under IRC 457 and IRC 501 can offer their employees this plan. You can contribute up to $20,500 per year to the plan or 100% of your latest yearly salary. Your money grows tax-deferred and is taxed in retirement.

6. U.S. savings bonds

Some U.S saving bonds offer tax-deferred options, such as the Series EE Bond and the Series I Bond. A U.S. savings bond is a bond provided by the government to its citizens. The money is usually used to fund federal spending. In return, the bond offers a guaranteed return to investors. These bonds are issued with a zero coupon. The Series EE bonds have a fixed rate of interest. These bonds also guarantee to double the investment in 20 years while the maturity term is 30 years. Contrarily, Series I bonds offer a fixed and variable rate and may be better to counter inflation.

The interest that you earn from any of these U.S saving bonds is not taxed immediately. You only pay tax when the bond expires or when you redeem your money. Additionally, you can also use an education tax exclusion to avoid income tax if you use the money to pay for qualified educational expenses.

7. Canadian Registered Retirement Savings Plan (RRSP):

RRSP is a tax-deferred retirement plan that can be used by Canadians. The account offers deferred growth until your withdrawals in retirement. Employees as well as self-employed individuals can use it. There are several types of RRSPs, such as individual, spousal, group and pooled RRSPs. Moreover, the account offers tax-deferred growth on interest earned, dividends received, as well as capital gains. 

As of 2022, the contribution limit for an RRSP is as below:

  • People can contribute up to18% of their annual earned income or up to a maximum of $29,210 per year.

To summarize

Tax-deferred retirement plans are a type of savings that can help you lower your tax liability. They allow you to save money in the present so you can invest more and build a bigger corpus. Moreover, considering the fact that your retirement income is likely to be lower than your current income, you get to save quite a lot of money in the long run. These accounts are helpful in other ways too. They let you save systematically and be financially disciplined. Moreover, you can invest in multiple products and enjoy several benefits at once. For instance, a 401k or an IRA lets you invest in stocks, bonds, mutual funds, and others. An annuity plan offers investment and insurance benefits under a single policy. So, make sure to use them wisely. You can select any of these options or invest in a combination of them according to your needs.

If you are unsure, you can also consult a financial advisor in your area and get professional guidance on different tax-deferred savings plans that match your future financial needs and goals. Use the free advisor match service to connect with 1-3 financial advisors based on your financial requirements. All you need to do is answer a few simple questions about yourself and the match tool will find advisors that match your financial needs.

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The blog articles on this website are provided for general educational and informational purposes only, and no content included is intended to be used as financial or legal advice.
A professional financial advisor should be consulted prior to making any investment decisions. Each person's financial situation is unique, and your advisor would be able to provide you with the financial information and advice related to your financial situation.