The 5 Best Types of Tax-Deferred Accounts
When you’re saving for retirement, the most popular type of investment account is a tax-deferred account. This allows you to defer your income taxes until a later date — usually when you withdraw money during retirement.
But with so many types of accounts to choose from, it can be understandably confusing to choose between them. Are you wondering if a tax-deferred account could be right for you and, if so, which one?
Keep reading to learn more about how tax-deferred accounts work, the different types of tax-deferred accounts available, and what you should know before opening one.
The Short Version
- A tax-deferred account allows you to defer taxes on your income and investments until a future date, giving you an immediate tax benefit.
- Tax-deferred accounts are different from tax-exempt accounts, which require taxation upfront but are exempt from taxes in the future.
- One of the most popular types of tax-deferred account is a retirement account, including 401(k) plans, 403(b) plans, 457(b) plans, and IRAs.
- Other types of tax-deferred accounts include tax-deferred annuities, permanent life insurance, and health savings accounts.
What Are Tax-Deferred Accounts?
A tax-deferred account is a type of investment account that allows you to defer taxes on both your income and investment returns until a future date.
Any money you contribute to a tax-deferred account won’t be subject to income taxes in the year you earn it. Additionally, you won’t pay taxes on any money you earn from your investments while the funds remain in the account.
Tax-deferred accounts, which are authorized by the IRS, are most often retirement accounts. They include 401(k) plans, individual retirement accounts, and even health savings accounts.
Related>>How to Invest for Retirement
How Do Tax-Deferred Accounts Work?
Tax-deferred accounts provide an immediate tax benefit for the investor. Contributions to these accounts aren’t subject to income taxes. Depending on the type of account, either your contributions are withheld from your paycheck before taxes or you can deduct your contributions when you file your income tax return.
Because your contributions are pre-tax, they reduce your taxable income — and, therefore, your tax liability — for the current year. For example, let’s say you have a taxable income of $75,000. If you contribute $10,000 to tax-deferred accounts, your new taxable income is $65,000. Because you’re paying taxes on less of your income, you’ll ultimately pay less income tax.
Read more>>What Are Pre-tax Investments?
Tax-deferred accounts also have longer-term tax benefits. In a taxable brokerage account, you would pay either income or capital gains taxes on your interest, dividends, and capital gains. But in a tax-deferred account, you’ll avoid all of these taxes.
In fact, you won’t pay taxes on the money in your tax-deferred accounts until you withdraw it, usually during retirement. When that day comes, you’ll pay income taxes on your distributions. But as long as you meet the distribution requirements for the particular type of account, you won’t be on the hook for any additional taxes or penalties.
Tax-Deferred Accounts vs. Tax-Exempt Accounts
Tax-deferred accounts are one of the two popular types of tax-advantaged accounts. The other type is a tax-exempt account.
While tax-deferred accounts have tax advantages today, tax-exempt accounts such as Roth accounts have a tax benefit in the future. When you contribute to a tax-exempt account, there’s usually no immediate tax benefit. Instead, you contribute to the account with after-tax money and pay the full amount of income taxes in the current year.
But once you contribute money to the account, you’ll never pay taxes on it again. The money grows tax-free in the account, and you can withdraw it tax-free during retirement, assuming you meet all of the distribution requirements.
Learn more about taxes on your investments>>Long-Term vs. Short-Term Capital Gains Tax
5 Best Types of Tax-Deferred Accounts
There are several types of tax-deferred accounts, each of which is used in certain situations and has its own rules.
Employer-Sponsored Retirement Plan
Many people get their start with investing through a retirement plan that’s sponsored by their employer. In 2023, these plans allow employees to defer up to $22,500 of their income, and there’s an additional catch-up contribution of $7,500 allowed for workers 50 and older.
Because these plans are offered by employers, they also allow for employer contributions. Some organizations offer to match their employees’ contributions up to a particular percentage of their income, while others contribute regardless of whether their employees do.
The type of plan you might be eligible for depends on the type of employer you have. Additionally, each type of plan allows for different investment options.
- 401(k) Plan: This type of plan is offered by for-profit companies in the U.S. and can be invested in a menu of investment options offered by the employer. Common investment options include mutual funds and target-date funds.
- 403(b) Plan: This type of plan is offered by public schools, churches, and non-profit organizations. They can be invested in annuity contracts offered by insurance companies or in custodial accounts invested in mutual funds.
- 457(b) Plan: This type of plan is offered by state and local governments and certain non-profit organizations. Like a 403(b) plan, 457(b) plan investments are generally limited to mutual funds and annuities.
An individual retirement account (IRA) is a type of retirement account that you open directly with a brokerage firm of your choice. Unlike the other plans we’ve discussed, IRAs aren’t offered through an employer. There are two types of IRAs for traditionally-employed individuals — traditional and Roth — but only traditional IRAs are tax-deferred.
IRAs have considerably lower contribution limits than other accounts. Unlike employer-sponsored retirement plans, you can only contribute the lesser of $6,500 per year or 100% of your earned income. There’s also a catch-up contribution of $1,000.
One of the benefits of IRAs is you can invest them in nearly anything. Unlike 401(k) plans, you aren’t limited to a short menu of investments offered by your employer. Instead, you can invest them in anything your brokerage firm offers.
Yes — ANYTHING>> How to Buy Crypto Inside a Retirement Account
Health Savings Account
A health savings account (HSA) is a type of tax-advantaged account designed to help you pay for medical expenses. You can open and contribute to an HSA if you have a high-deductible health plan, meaning one with a deductible of $1,500 for an individual or $3,000 for a family. You can contribute up to $3,850 for an individual or $7,750 for a family each year.
Though we include HSAs in our discussion of tax-deferred accounts, they technically aren’t tax-deferred. HSAs have a triple tax advantage. First, like a tax-deferred retirement account, you contribute to the account with pre-tax money, meaning you can reduce your taxable income in the current year.
But then your money grows tax-free in the account, and you can withdraw it tax-free as long as you spend it on qualified medical expenses. However, if you spend it on anything else, you’ll be subject to both taxes and a penalty on your distributions.
The reason we include HSAs in our list of tax-deferred accounts is that you can choose not to use the money for medical expenses. Instead, you can invest the money in the account. And once you reach age 65, you’ll be able to use the money for any purpose without paying an additional penalty. You’ll only be on the hook for the income taxes. In this way, the HSA can serve as a retirement account.
Related>>How Many Financial Accounts Are Too Many?
A tax-deferred annuity is a type of annuity that allows you to save for the future outside of your normal retirement accounts. You can’t deduct your contributions as you would with a 401(k) or an IRA.
However, once you’ve put money into the annuity, you won’t pay taxes on your earnings until you withdraw money later on (usually during retirement). Tax-deferred annuities can have investment returns that are either fixed, indexed, or variable.
There are potential downsides to annuities that you should be aware of. One is that you typically have to pay a surrender charge if you want to cash out your investment early. Also, annuities typically have higher fees than other types of investments, which can eat into your returns.
Permanent Life Insurance
Most people don’t think of life insurance as an investment account, but it can certainly serve as one. With permanent life insurance, a portion of your premiums goes to pay for your death benefit, just as they would with term life insurance. But the premiums for this type of insurance are considerably higher, and the remaining amount goes to build your cash value.
There are different types of permanent life insurance, some of which have a guaranteed rate of return, while others have a variable or indexed rate of return, similar to annuities. You can borrow against the cash value later in life, use it to pay your premiums, or withdraw it entirely. And like other types of tax-deferred accounts, you won’t pay taxes on the investment earnings until you withdraw the money.
We generally don't recommend permanent life insurance over other tax-deferred account options. However, a whole life policy could be worth considering for high-income or high-net-worth individuals.
What to Know Before Opening a Tax-Deferred Account
Opening a tax-deferred account can be an excellent way to prepare for the future, specifically retirement. Thanks to the powerful tax advantages these accounts offer, your hard-earned savings can go toward future living expenses and less toward taxes.
However, the disadvantage of a tax-deferred account is that it has less liquidity than a taxable account. This means that you may have to pay taxes on the money you withdraw, even if you need it for an emergency.
In the case of retirement accounts (like 401ks and IRAs), the IRS requires that you keep the money in the account until you reach 59½. While there are a few situations where you can withdraw money early — including financial hardship — you’ll usually be subject to a 10% penalty for early withdrawals.
So, if you're looking for an investment account with the most growth potential, a tax-deferred account is the way to go. However, if you need access to your money and don't want to worry about taxes, a taxable account may be the better choice.
Bottom Line: Should You Open a Tax-Deferred Account? (And Which One?)
When it comes to deciding which type of account is best, start with your employer. It’s likely the company or organization you work for offers one of the tax-deferred accounts we mentioned above. And if they don’t, consider opening a traditional IRA or another account to get a jumpstart on investing for the future.
If possible, it’s best to start contributing to a tax-deferred or otherwise tax-advantaged account as soon as you join the workforce. Through the power of compound interest, what seems like a relatively small contribution in your early twenties can go on to make you a millionaire by retirement.
Learn more about really long-term savings>>
- Best Retirement Planning Tools & Calculators for 2023
- Different Types of Trusts and Why You Should Create One
- Investing for Retirement When You Have Little or No Savings
- Roth IRA Conversion Ladder: Ultimate Tax Hack for Early Retirees?