Tax-deferred: Meaning, how it works + examples

In the lead-up to early retirement, you need to be making the right choices with your investments to achieve financial freedom. One of the best ways to do that is avoiding taxes whenever legally possible. But you can’t always do that, so what’s your next-best option?

You can elect to have some income taxes deferred, meaning delaying tax payments on certain types of income and investments until later. This can save you big money on taxes in retirement, especially if you end up in a higher tax bracket when the time comes. Even if you are in a comparable, or lower, income tax bracket in retirement, reducing tax drag may still create more long-term value.

In this guide, we’ll dig into the meaning of tax-deferred income, name the top benefits of deferring taxes, and give examples of how to defer taxes with certain accounts.

What does tax-deferred mean?

Tax deferral is postponing tax payments until you withdrawal money from a tax-deferred account at a later date. It’s like doing a financial tango with the IRS that promises to last a certain amount of time while you kick the tax can further down the road.

If you’re stashing money into a tax-deferred account, like a traditional IRA or a 401(k), the IRS essentially grants you a temporary tax shelter. The money you contribute to these accounts doesn’t immediately count as taxable income.

Income tax deferral can help your investments compound over time without tax liabilities slowing your gains. However, in most cases, you can’t touch your investments without incurring a penalty.

When you eventually withdraw the money from your tax-deferred accounts, Uncle Sam returns, hat in hand, expecting his cut. And if you’re in a higher tax bracket than when you initially contributed the money, you might be playing a losing game.

6 benefits of tax deferral to grow your income long-term

Tax deferral isn’t just fancy finance jargon – it’s a potent strategy that can boost your wealth over the long haul. Now, let’s dive into the top benefits that tax-deferred growth offers.

1. Compound growth with the snowball effect.

When growing your wealth, little beats the power of compounding. Tax-deferred accounts are one way to take advantage of this phenomenon because your pre-tax investments can grow without taxes constantly nipping at their heels.

So, your returns generate returns, and those returns generate more returns, creating a snowball effect of wealth accumulation. The longer you leave your money invested, the larger this snowball becomes and the faster it grows over time.

2. Keep more of your money with lower current tax liability.

If you’re earning a comfortable income but would rather hold off on handing a chunk of it over to the IRS, tax-deferred accounts let you reduce your taxable income today. By contributing to these accounts, you’re telling the IRS: “Hold off on those taxes for now, I owe you.”

This lowers your current tax bill and frees up more money to invest.

As of 2023, you can also claim a deduction on contributions to an IRA if you don’t contribute to an employer-sponsored plan or if you do contribute to one but your modified adjusted gross income is less than $73,000 or $116,000 if you're married and file taxes jointly.

3. Plan strategic retirement withdrawals by shifting income.

Fast-forward to your retirement years. Chances are, your income looks quite different. Tax-deferred accounts allow you to postpone taxes, so you can strategically withdraw money when your tax rate is lower.

However, you might have a higher income during retirement and fall into a higher tax bracket. In that case, a backdoor Roth IRA could be a better option today than a tax-deferred account since your returns and withdrawals in retirement will all be tax-free. A backdoor Roth IRA is when you take after-tax funds in a traditional IRA and move them to an after-tax Roth IRA. It's a strategy often used by those who make too much money to contribute directly to a Roth IRA. Individual income is limited to $153,000, while married filers can make up to $228,000 in 2023.

4. Pass on your legacy through estate planning.

Your financial legacy matters and tax-deferred accounts can be pivotal in estate planning. When you pass away, these accounts can be left to your heirs with potential tax advantages.

This means you can pass on your hard-earned wealth more efficiently, helping your loved ones navigate their financial journeys with fewer tax burdens. That way, you’re passing on wealth and the knowledge that tax minimization helps build bigger piggy banks over time.

5. Balance your portfolio with asset location and diversification.

Tax-deferred accounts complement a well-rounded investment portfolio. Asset location helps you manage and possibly reduce your tax liability over time: your least-tax-efficient assets go into a tax-deferred IRA and that reduces tax drag.

By diversifying your assets, you have a mix of tax-deferred, tax-free, and taxable assets in retirement so that no matter what happens to the tax code you have options.

6. Retire comfortably.

Finally, and most importantly, tax deferral helps you prepare for retirement. It ensures you have a financial cushion to support your lifestyle when you leave the workforce.

By reducing your tax liabilities in retirement, you can enjoy your golden years with greater financial security.

Examples of tax-deferred accounts

To take advantage of tax deferral, you should know the common types of accounts that fit this strategy, as well as other tax-minimization strategies that complement tax deferral.

There are four main types of deferral investments:

There are also SEP and SIMPLE IRAs. A SEP IRA is only for employers to contribute to their and their employees’ accounts, while a SIMPLE account is for businesses with less than 100 workers and is funded by both employers and employees.

Pension plans are also a tax deferral strategy if one is available to you. However, only certain employers in select sectors offer them. If you have a pension plan, your contributions aren’t taxed until you withdraw from the fund.

There are a lot of factors that go into finding the right mix of accounts. Playbook builds the plan to help you know you're doing the right thing with your money.

Tax-deferred vs. tax-free: Are they different?

The main difference between tax-deferred vs. tax-free is that you contribute pre-tax income to tax-deferred accounts and pay taxes later on your withdrawals, while you contribute post-tax income to tax-free accounts and pay no taxes on what you pull out later.

Common tax-advantaged accounts are Roth IRAs and health savings accounts (HSAs).

If you follow the rules with a tax-free account, you’ll even be able to enjoy your spoils tax-free. That is, the gains your tax-advantaged account earns before you make withdrawals won’t incur any tax penalties. This makes tax-advantaged accounts a huge bounty for early retirement wannabes.

Here are some other key differences between tax-deferred and tax-advantaged accounts:

• Tax breaks: Tax-deferred accounts offer tax breaks on contributions, while tax-free accounts provide them on withdrawals without immediate tax consequences on investment gains.
• Penalties: Tax-deferred accounts usually have penalties for early withdrawals before age 59½, while some tax-free accounts allow penalty-free withdrawals for a specific purpose (for example, using an HSA for medical expenses).
• Income limits: Certain tax-free accounts, like Roth IRAs, have income limits for eligibility, while many tax-deferred accounts don’t. However, high earners can still reduce taxes by opting for a backdoor or mega backdoor Roth conversion.
• Distributions: Required minimum distributions (RMDs) are when tax-deferred accounts force you to start withdrawing a minimum amount at a certain age. Tax-free accounts don’t have RMDs.

Generally, for those who foresee their tax bracket decreasing in retirement, tax-free investments will provide a superior wealth-building option. With no tax drag and a flexible withdrawal strategy, tax-advantaged accounts make retirement planning simpler.

Other tax minimization strategies to maximize growth

Tax deferral isn’t the only way to grow your wealth until it’s long in the tooth. Try these complementary strategies:

• Smart location: Not all investments are taxed the same; some fare better in tax-advantaged accounts (like those with higher return potential), while others will do better in tax-deferred accounts. This tax-efficient fund placement makes your portfolio work smarter to take advantage of the best wealth-boosting accounts for your funds.
• Smart withdrawals: Tax-deferred accounts tax you when you withdraw, and tax-free accounts tax you when you contribute. To maximize your growth, plan strategic withdrawals so your tax bracket is lower when you pull from tax-deferred accounts and higher when you pull from tax-free ones.
• Tax-loss harvesting: Sometimes, a loss is inevitable. However, you might be able to take advantage of losses on certain investments to reduce your tax liability. By using tax-loss harvesting, you are effectively postponing paying any tax on gains until later on in life.

Don’t let taxes derail your retirement goals.

Tax deferral isn’t just about avoiding taxes today; it’s about harnessing the power of time and smart financial planning to build lasting wealth. It’s a secret weapon on the journey to financial freedom, allowing you to keep more money, protect your assets, and pave the way for a brighter financial future.

Your other secret weapon is Playbook. We help you take control of your financial goals and build wealth over time so you can retire earlier – all the while, you get to take your mind off your money and let it grow in peace.