When you invest money, you normally have to pay federal and state tax on your earnings. You can delay paying those taxes by investing some of your money in tax-deferred rather than taxable accounts. You do not pay tax on money held in a tax-deferred account until you make withdrawals, which means that your earnings compound faster than in a taxable account. However, tax-deferred accounts do have drawbacks and limitations; these accounts are not ideal for everyone.
When you make a withdrawal from a tax-deferred account, you have to pay taxes on any portion of the money that was not taxed prior to being deposited in the account. On most types of tax-deferred accounts, you make your deposit on a pretax basis, so your withdrawals are fully taxable. You pay ordinary income tax on the withdrawal; depending on your tax bracket, that could mean paying up to 35 percent tax. On a taxable account you only pay income tax on investments that you hold for less than a year. On longer-term investments you pay capital gains tax, which amounts to just 15 percent. Therefore, while you miss out on tax-deferred growth, you may end up losing a lower percentage of your investment proceeds to taxation when you invest in taxable accounts.
The Internal Revenue Service allows funds inside retirement accounts to grow on a tax-deferred basis as a way of encouraging investors to save for retirement. For tax purposes, the IRS uses age 59 1/2 as the retirement age. If you access money inside your tax-deferred account before reaching that age, you incur a 10-percent withdrawal penalty. You do not pay this penalty if you use the money for certain "qualified" expenses, like college tuition or medical costs. With a taxable account, you can buy and sell securities regardless of your age without incurring any kind of tax penalty.
Anyone can invest in a taxable account, since no income restrictions apply. Furthermore, you can invest with money that you earned during the current year or with the cash proceeds from existing taxable investments that you decide to sell. Annual restrictions apply to investments in tax-deferred accounts. As of 2011, annual contributions to individual retirement arrangements (IRAs) are capped at $5,000 per year for people under 50 and $6,000 per year for older investors. Income restrictions also apply to people who are covered by employer-sponsored tax-deferred pension plans, and contribution and income limits apply to other types of tax-deferred accounts. Therefore, tax-deferred accounts are not an option for everyone.
The longer you can keep money inside a tax-deferred account, the more you can take advantage of the tax-deferred growth by reinvesting dividends and interest that would incur income tax on other types of investments. Roth IRAs grow tax-deferred but contain after-tax money, and you can withdraw funds penalty free after holding the money for five years once you reach the age of 59 1/2. However, while Roths are one type of tax-deferred account that provides tax-free income, you can only invest in a Roth if your modified adjusted gross income stays below a certain level. Therefore, most investors end up using both taxable and tax-deferred accounts rather than investing exclusively in one account type.
- IRS.gov; Retirement Plans FAQs Regarding IRAs; July 2008
- Charles Schwab; Calculate the Cost Before You Sell; Rande Spiegelman; January 2011
- IRS.gov; 401(k) Resource Guide - Plan Participants - General Distribution Rules; May 2011
- "AAII Journal"; The Investment Implications of Tax-Deferred vs. Taxable Accounts; William Reichenstein; April 1997
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