Tax-Deferred Savings Plan

What Is a Tax-Deferred Savings Plan?

A tax-deferred savings plan is an investment account that allows a taxpayer to postpone paying taxes on the money invested until it is withdrawn, generally after retirement. The best-known such plans are individual retirement accounts (IRAs) and 401(k)s.

Tax-deferred savings plans are qualified by the Internal Revenue Service (IRS) and allow the taxpayer to pay money into the plan and subtract that amount from their taxable gross income for that year. The taxes on the contribution and its investment returns will be due only when the money is withdrawn, generally after the taxpayer retires.

For IRAs, contributions to traditional IRAs are tax-deductible, with some income limitations if the taxpayer or their spouse has a retirement plan at work. Contributions to Roth IRAs are not tax-deductible, and there are income limits on who may contribute to a Roth IRA. However, money held in both types of IRAs grows tax free until it is withdrawn.

Benefits of Tax-Deferred Plans

The tax-deferred savings plan was approved by the federal government as a way to encourage Americans to save for retirement. An individual may contribute a portion of pre-tax earnings to an investment account.

There are several benefits to the individual:

Tax-deferred 401(k) and IRA plans

Many companies offer employees a 401(k) for tax-deferred retirement savings. There are similar vehicles such as the 403(b) for public service employees and the 457 for government employees.

When an employer sponsors the plan, some employers also match a portion of the employee's contribution up to a certain level (3% is typical).

The self-employed and virtually anyone else with some amount of taxable compensation can open an IRA account. These are available through banks and brokerages, with a wide range of investment options.

At age 72, holders of 401(k)s and traditional IRAs must take required minimum distributions (RMDs), which are generally taxable at individual income rates.

Other tax-deferred savings options

In addition to 401(k) plans and IRAs, several other types of investment offer tax deferral:

The interest on some U.S. savings bonds is tax-deferred and may be tax-exempt if the money is used for some educational expenses.

Non-Penalized Early Withdrawal

If the withdrawal meets one of the following stipulations (among many others), it could be exempt from the early withdrawal penalty:

The Bottom Line

A tax-deferred savings plan allows you to put off taxes on your invested money until you need it in retirement. Many vehicles to accomplish this are well-known, but if you have questions check with a financial planner or tax expert.