Tax-Deferred

Tax-deferred means you do not pay income taxes on money right away. Instead, the taxes are postponed until a later date, usually when you withdraw the funds in retirement. This allows your investment to grow without being reduced by taxes each year.

Many common retirement accounts work on a tax-deferred basis. When you contribute money to these accounts, you reduce your taxable income for that year. The money then grows over time, and you only owe taxes when you take the money out.

Common tax-deferred accounts include:

• Traditional 401(k) plans
• Traditional IRA accounts
• 403(b) plans for teachers and nonprofit workers
• 457(b) plans for government employees

For 2026, the contribution limit for a 401(k) is $23,500 per year. Workers aged 50 and older can add a catch-up contribution of $7,500, bringing their total to $31,000. For a Traditional IRA, the limit is $7,000 per year, with a $1,000 catch-up for those 50 and older.

Here is a practical example: Suppose you earn $60,000 a year and contribute $5,000 to a Traditional IRA. You would only pay income taxes on $55,000 that year. The $5,000 grows inside the account without annual taxes eating into the gains. When you retire and start withdrawing, those withdrawals are taxed as ordinary income at whatever rate applies at that time.

The main benefit of tax deferral is the power of compounding. Because your full balance keeps growing without annual tax reductions, your money has more potential to build over decades. However, there is a trade-off. The IRS requires you to start taking money out through Required Minimum Distributions, or RMDs, beginning at age 73. This prevents taxes from being deferred forever.

Tax-deferred accounts work best for people who expect to be in a lower tax bracket in retirement than they are today. If you expect your tax rate to be higher later, a Roth account, which is funded with after-tax dollars, might be worth exploring instead.

RetireGrader is not a financial advisor or fiduciary. This definition is for educational purposes only.