What is Tax Deferred?
In the investment world, 'tax deferred' refers to investments on which applicable taxes (typically income taxes and capital gains taxes) are paid at a future date instead of in the period in which they are incurred.
How Does Tax Deferred Work?
For example, consider the traditional Individual Retirement Account (IRA). If an investor places $100,000 into an IRA in 2000 and the account earns $10,000 in 2001, the investor does not owe taxes on that $10,000 in 2001. Instead, the investor must pay the taxes when he or she withdraws the money from the IRA, which could be decades later.
Tax deferred investments not only help investors avoid cash outflows for taxes in the immediate future, but they can help investors generate higher returns. That's because the money that would normally be used for tax payments is instead allowed to remain in the account and earn a return.
For example, if the IRA investor mentioned above is in a 33% tax bracket, she would have had to pay $3,333 in income taxes on the $10,000 earned on the IRA in 2001. That would have left $6,667 in capital gains in the account. At a 10% annual return, those earnings would go on to produce $667 in 2002. However, because IRAs are tax deferred, the investor is able to earn a return on the full $10,000 rather than the $6,667 she would have had if she had to pay taxes that year. At a 10% annual return, she'd earn $1,000 in 2002. As you can see, the advantage of tax deferral compounds with each year.
Why Does Tax Deferred Matter?
It is important to note that 'tax deferred' is not the same as 'tax exempt,' which refers to the absence of applicable taxes. Remember, tax deferral means taxes are assessed but payment is delayed; tax exempt means taxes are never assessed on the investment in the first place.
As investors move into higher and higher tax brackets, tax-deferred investments become more and more advantageous. However, it's important to note that there are often financial penalties for withdrawing funds from tax deferred accounts before a certain amount of time has passed, making tax deferred investments better for long-term investors.
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