What is a Tax-Deferred Savings Plan?
A tax-deferred savings plan is an account that allows the account holder to postpone paying taxes on the investments in the account.
How Does a Tax-Deferred Savings Plan Work?
A 401(k) plan is the most common example of a tax-deferred savings plan. An investor with a 401(k) is allowed to make contributions to the plan (i.e. buy investments within the account) with money that has not been taxed by the government yet. The contributions grow tax-deferred until the investor decides to begin taking distributions. When the investor begins taking money out of the account, only then will the withdrawals be taxed.
Why Does a Tax-Deferred Savings Plan Matter?
Tax-deferred savings plans are a key part of retirement planning because they allow investors to compound their returns on much higher principal balances, since taxes are not taken out up front. Furthermore, the account holders don't pay taxes until they are retired and most likely in a lower tax bracket.
IRAs and education savings plans are other popular tax-deferred savings plans.