What is a tax-deferred retirement plan?

How do tax-deferred retirement plans work?

Retirement is an exciting milestone that many of us eagerly anticipate. Planning for it is a necessary and rewarding process, especially when it comes to securing your financial future. Tax-deferred retirement plans are important, simply put, because they allow your savings to grow faster.

Tax-deferred retirement plans help you save for the future more effectively. Your contributions and their growth are tax-deferred until you withdraw the funds in retirement. Why does that matter? In addition to lowering your current tax obligation through pre-tax contributions, these investments can grow tax-deferred each year, depending on the types of investments you make. Sometimes it’s a little. Sometimes it can be a lot.

Normally you would have to pay taxes on this growth. That could include federal and state income taxes, or even capital gains tax. But with tax-deferred retirement plans, you usually don’t pay taxes until you start to withdraw the money. It may not seem like much in the beginning, but the money earned through compound interest can add up quickly.

Because tax-deferred accounts are such a powerful way to save, rules were created around how much you can add to them each year. These contribution limits prevent high earners from gaining an unfair advantage over those who earn less. Various limits apply, depending on the type of account and your age. Read on for more on contribution limits.

Types of tax-deferred retirement accounts

Just as there are many ways to spend your time during retirement, there are several tax-deferred ways to save for it. 401(k)s, Individual Retirement Accounts, and deferred annuities are common ways to take advantage of tax-deferred savings as you plan for retirement.

401(k)s

401(k)s are employer-sponsored retirement savings accounts that provide significant tax benefits. Traditional 401(k)s are funded with pre-tax dollars, meaning that you take money from your gross income before it’s subject to taxes. This lowers your current taxable income, and the money placed in an account is allowed to grow tax-deferred. You only pay taxes on it when you take disbursements during retirement.

Individual Retirement Accounts

IRAs have the same tax benefits as 401(k)s. Traditional IRAs are funded with pre-tax dollars, while Roth IRAs are funded with after-tax dollars. However, IRAs and 401(k)s have different contribution limits, and IRAs offer more control than 401(k)s. IRAs are not tied to your employer, providing more flexibility and options for how they’re managed.

Deferred Annuities

Fixed deferred annuities provide you with regular income payments during retirement. The money you put into them grows tax-deferred. If an account was funded with pre-tax dollars, the full amount of the disbursements you receive each period will be taxable.

Other tax-deferred savings accounts

In addition to the tax-deferred savings accounts that help with retirement planning, there are others that can be used for ongoing or short-term needs:

529 Education Savings Plans

A 529 is a savings plan that lets you set aside money for education and enjoy tax-deferred growth. If the money is used for qualified educational purposes, no taxes are due on the disbursements. While an education fund might not be the first thing that comes to mind when you think of retirement planning, a 529 can help you fund the future education of a child or grandchild while helping you keep more your savings. It’s important to note that 529 plans are subject to market risk.

Health Savings Accounts

Health Savings Accounts (HSAs) offer a tax-advantaged way to save for medical expenses and grow tax-deferred while the funds are in the accounts. Contributions are tax deductible, and withdrawals used for qualified medical expenses are tax free. This can be a significant benefit, especially later in life.

Benefits of tax-deferred retirement accounts

Optimizing your savings strategy can help increase the likelihood that your nest egg grows to meet your future needs. Tax-deferred accounts and investment options help you maximize your long-term growth by allowing your money to grow faster through the power of compounding interest. Since you don’t have to reduce the account balance to pay taxes on the growth, you also earn interest on previously earned interest. Delaying taxes until retirement can also be beneficial because you may be in a lower tax bracket than you were before retirement.

For those in higher tax brackets after retirement, accounts funded with after-tax dollars like Roth 401(k)s and Roth IRAs help you cut down on taxes owed during retirement. It’s also worth noting that the earnings withdrawn from these accounts are also tax free if certain requirements are met.

How much can you put into tax-deferred accounts?

Contribution limits can vary from year to year and among different types of accounts. For example, 401(k) contribution limits differ from IRA contribution limits. Some people maximize their tax-deferred contributions by investing in multiple types of accounts. And people aged 50 and above are allowed to make catch-up contributions above the regular contribution limits.

What happens if you have too much in tax-deferred accounts?

If you contribute too much to a tax-deferred account, you could be taxed twice on the overage, and if you’re under 59½, you may be subject to early-withdrawal penalties. To avoid penalties, you’ll need to withdraw the overage by a specific date. In the case of a 401(k), you should contact your employer or plan administrator right away. You may also need to get a new W-2 and amend your tax return. It’s best to consult a tax professional to make sure any issues are resolved correctly.

Retirement savings plans can benefit significantly from the prudent use of tax-deferred strategies. By contributing to accounts like IRAs and 401(k)s, you can delay paying taxes on your earnings until you withdraw them, allowing your money the potential to grow faster through the effects of compound interest over time. The help of a financial professional can help you make the most of these savings opportunities.

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Neither New York Life Insurance Company, nor its agents, provides tax or accounting advice. Please consult your own tax or accounting professional before making any decisions.