Tax-Deferred Account
Definition
An investment account where contributions reduce current taxable income and earnings grow without annual taxation, but withdrawals in retirement are taxed as ordinary income.
Tax-deferred accounts — including traditional 401(k)s, traditional IRAs, 403(b)s, and 457(b)s — delay your tax liability from now until withdrawal. Contributions reduce your taxable income today, and all dividends, interest, and capital gains within the account are not taxed until you take distributions in retirement.
The tax deferral advantage is substantial. If you invest $10,000 annually for 30 years at 8% returns: in a taxable account (assuming 25% tax on gains), you'd have approximately $760,000. In a tax-deferred account, you'd have approximately $1,130,000 — the full compounding benefit with no annual tax drag. Of course, you'll pay tax when you withdraw, but the extra decades of compounding on pre-tax dollars is powerful.
Tax-deferred accounts are most beneficial when you expect to be in a lower tax bracket in retirement than your current bracket. If you're in the 32% bracket now and expect to be in the 22% bracket in retirement, deferring saves you 10% on each dollar contributed. If you expect the same or higher bracket, a Roth (tax-free) account may be better.
Required Minimum Distributions (RMDs) begin at age 73, forcing you to start withdrawing from tax-deferred accounts and paying the deferred taxes. This prevents indefinite tax deferral and creates taxable income in retirement that must be planned for.
A common strategy is "tax bracket management" — converting some tax-deferred assets to Roth during low-income years (between retirement and RMDs, or during career gaps) to fill up lower tax brackets with tax-free Roth conversions. This smooths the lifetime tax burden and reduces future RMDs.
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Related Terms
Frequently Asked Questions
Should I use tax-deferred or Roth accounts?
Use tax-deferred when your current tax bracket is higher than you expect in retirement. Use Roth when your current bracket is low or you expect higher rates in the future. Many advisors recommend contributing to both for tax diversification — giving you flexibility in retirement.
Can I convert tax-deferred to Roth?
Yes — Roth conversions move money from a traditional IRA/401(k) to a Roth. You pay income tax on the converted amount now, but future growth and withdrawals are tax-free. Conversions are most beneficial during low-income years when you're in a lower tax bracket.