Tax-deferred accounts are investment vehicles that accumulate interest, dividends or capital gains — earnings that remain tax-free until the investor makes a withdrawal, usually at the time of retirement. The most common tax-deferred accounts are traditional individual retirement accounts (IRAs), retirement investments established through employers, simplified employee pension (SEP) accounts and deferred annuities. Earnings on tax-deferred investments have unrestricted growth potential, and withdrawals typically occur when the investor has a lower tax rate.
Traditional IRAs are retirement plans that provide annual limits for individuals to invest pretax income. Commercial banks and retail brokers act as custodians for IRAs. Contributions are invested in mutual funds, stocks, bonds or other financial assets. Distributions from traditional IRAs are subject to income tax deductions similar to ordinary income, unlike accounts that have tax-free distributions.
In some countries, employers can establish tax-deferred accounts for eligible employees. An example is the 401k plan in the United States. Employees make salary deductions on a pre-tax or post-tax basis, and taxes are deferred on the earnings. Employers can match employee contributions and add profit sharing to the plan.
Government regulations typically limit the amount of salary contributions that an employee can make. Employees may have the option to select investment products or have an investment firm manage the assets. These plans also define the retirement age for withdrawals. Restrictions and penalties apply if an employee withdraws money before retirement.
The Simplified Employee Pension (SEP) account has two types of plans which qualify as tax-deferred accounts. The two categories are defined contribution plans and defined benefit plans. These employer-sponsored plans are easier for small businesses to administer than a conventional pension plan.
A defined contribution plan is an individual account in which either an employee or employer contributes to the plan. Market conditions determine the payout of a defined contribution plan. The employer maintains a fund for participating employees in a defined benefit plan. This fund generates a monthly check based on an agreed amount when the employee retires.
An investor can receive delayed installments or a lump sum payment from a deferred annuity. Savings accrue in these tax-deferred accounts with a variable or fixed interest rate. Earnings are taxed at the time of withdrawal.
A person who has a deferred annuity determines the date payment will begin. Payments can be deferred until retirement or begin sooner. A deferred annuity also has a death benefit that guarantees that the principal and investment earnings are paid to the assigned beneficiary.