What is a tax-deferred savings plan?

A tax-deferred or tax-sheltered savings plan is an investment scheme that allows taxpayers to not pay any taxes on the investment until the funds are withdrawn. These funds are generally withdrawn by taxpayers after retiring. The tax authorities allow subtracting the amount invested in these plans from their taxable income every year until retirement.

Types of tax-deferred retirement savings plans

401 (k)

One of the accounts used under the tax-deferred retirement savings plan is called the 401 (k). It is named after a section in the US Internal Revenue Code. The 401 (k) is an investment account that is generally offered by employers to employees in need of a retirement plan. A part of the paycheck is contributed periodically for this purpose. The employee gets to choose how these savings are further invested. Traditionally, mutual funds are chosen. 401 (k) can be further classified into two: Traditional 401 (k) and Roth 401 (k). The difference between these two accounts is the way they are taxed.

Individual Retirement Account (IRA)

Another account used for a tax-deferred retirement savings plan is called the Individual Retirement Account or IRA. Any individual with a steady income can open an IRA. Through the IRA, the individual can invest long-term and also avail tax benefits along with it. IRA can be opened with a personal broker, an online brokerage, an investment company, or a bank. The money held in an IRA cannot be withdrawn by the investor before reaching the age of 59.5. Premature withdrawal could cost a penalty as high as 10% of total investment. IRA is further classified into four different accounts: Traditional IRA, Roth IRA, SEP-IRA, and SIMPLE IRA.

Traditional IRA

It allows taxpayers to invest a pretax amount that can grow tax-free until retirement. After retirement, the withdrawn funds are taxed at the individual’s income tax rate. Capital gains and dividends earned through investments are tax-free. Investors with a retirement plan can open a traditional IRA through a financial adviser or broker. There are different contribution limits set for traditional IRAs for those under 50 and those above 50.

Roth IRA

It is a savings plan whose contributions are not tax-deductible. In other words, the employees' after-tax income is used to make Roth contributions. However, any gains made on the investment are not taxable. No taxes need to be paid on funds withdrawn after retirement. There is no age limit for contributions either, an individual can contribute as long as they have an income. The contribution limits are the same as traditional IRA however Roth IRA has an income limitation.

Under traditional and Roth IRAs, there could also be a factor called spousal IRA. Under spousal IRA, a working individual could make the contributions on an IRA account opened in the name of the spouse. They are individual accounts with the same rules however the contributions are done by the spouse.

Some other tax-deferred retirement plans

SEP IRA

It stands for Simplified Employee Pension Individual Retirement Account. This savings plan is for self-employed persons such as independent contractors, freelancers, entrepreneurs, etc. The tax rules of SEP IRA are the same as traditional IRA. Entrepreneurs can also open SEP IRA accounts for their employees and gain a tax advantage. The employees cannot make contributions to these accounts by themselves however they will be taxed upon withdrawal.

SIMPLE IRA

It stands for Savings Incentive Match Plan for Employees Individual Retirement Account. This savings plan is also for entrepreneurs and small-business owners. This IRA type also has tax rules that are similar to the traditional IRA. Unlike SEP-IRA, SIMPLE IRA allows employees working under business owners to make their contributions to the account. All contributions made into this savings plan are tax-deductible. There are different contribution limits set for SIMPLE IRAs for those under 50 and those above 50.

A beneficiary is required for all IRA accounts. The beneficiary will receive the amount on behalf of the investor in case of death before the exhaustion of assets. If the beneficiary is under the retirement age set for the account, the same withdrawal and distribution rules apply to the beneficiary.

Benefits of tax-deferred retirement account

The defined benefit of a tax-deferred account is that the working individual could invest in these accounts while saving tax expenses. Individuals tend to believe that reducing tax expenses using a tax-deferred account while working is so much more beneficial than paying taxes on funds withdrawn after retirement. This is because after retiring and living only on retirement income saved as per the retirement plan, the individual falls under a lower tax bracket. Additionally, by reducing tax expenses, the individual can deposit more of their income in savings accounts.

The effect of compounding provides a large advantage for investors. All the interest earned on the investment could be invested back to earn even more interest. This cycle continues for years and there is no tax paid on these investments while they increase.

In case of unfavorable conditions before the age of 59, the funds could be withdrawn to manage those conditions. To encourage savings, the penalty of 10% is applied. However, the penalty may not be applied in case of certain circumstances. These circumstances include permanent disability, higher education expenses, health insurance premiums while unemployed, etc.

Additionally, the existence of these accounts and the tax advantage offered to cultivate a saving discipline in individuals early on in their careers. Individuals falling under the legal working age that has an income can start retirement planning or retirement savings early on in their life.

Context and Applications

The aspiring students can pursue further specialization in this field by undertaking the following courses

• Masters in Finance
• Bachelors in Finance
• Masters in Business Administration (Finance)

Practice Problems

1. Which of the following is an employer-sponsored retirement plan?

1. 1. 401 (k)
   2. Roth IRA
   3. Spousal IRA
   4. Traditional IRA

Answer: (a) 401 (k).

Explanation- 401 (k) named after the income tax section falls under employer-sponsored retirement plans while traditional and Roth IRAs are opened directly by taxpayers.

2. Which of the following is not a tax-deferred account?

1. 1. Traditional IRA
   2. Simple IRA
   3. Roth IRA
   4. SEP IRA

Answer: (c) Roth IRA.

Explanation- In the Roth IRA account, the contribution is done on after-tax income while non-Roth accounts’ contributions are done on pre-tax dollars.

3. Which of the following is a penalty for early withdrawal?

1. 1. 25% of total investment
   2. 10% of total investment
   3. 50% of total investment
   4. 75% of total investment

Answer: (b) 10% of total investment.

Explanation- The 10% of total funds are deducted in case of premature withdrawal of a tax-deferred retirement plan. There are however certain exceptions to this such as medical expenses on disability, education expenses, etc.

4. In case of death of the fund contributor, who receives the funds?

1. 1. Employer
   2. Beneficiary
   3. Income tax authorities
   4. Financial advisor/ broker

Answer: (b) Beneficiary.

Explanation- Account-holders are required to nominate beneficiaries such as spouses to avail the funds in case of death.

5. Which of the following is a feature of SIMPLE IRA?

1. 1. The funds contributed to a SIMPLE IRA are the after-tax income.
   2. The employer can only contribute to an account opened by him/her.
   3. The employee can contribute to an account opened by the employer.
   4. The spouse of the employee can contribute to an account opened by the employer.

Answer: (c) The employee can contribute to an account opened by the employer.

Explanation- SIMPLE IRA is an account opened for retirement planning for small-business owners and their employees. The employees could also contribute to accounts opened for them for this purpose.

Common Mistakes

It is incorrect to assume that an individual who has a 401 account through an employer cannot open an IRA account. While employer contribution is helpful, an individual may want additional savings as per his/her retirement plan. Therefore, the opening of more than one account is permitted. However, there will be an overall contribution limit set as per the types of accounts and income of the individual.

Related Concepts

While studying the tax-deferred retirement benefits, it is important to read the following to get a better knowledge:

• Income tax laws
• Tax-free investments
• Compounding interest