Tax deferral — Postponing taxes to help your money grow

Procrastination is not usually seen as a positive trait. But there’s a form of procrastination that just might help you build wealth: using retirement savings accounts to put off paying some of your income taxes.

Tango with two tax breaks

A tax-deferred savings account, like an Individual Retirement Account (IRA) or a 401(k), may provide two powerful tax advantages:

• An immediate deduction — Contributions to an employer-sponsored retirement plan and to traditional IRAs, can reduce your taxable income dollar-for-dollar (up to certain IRS limits).¹ This may lower your current federal income taxes. Instead of paying Uncle Sam, you’re investing the money where it has the opportunity to grow and generate income for you down the road.
• Long-term deferrals — Earnings in your retirement account aren’t taxed until you withdraw the money, which means 100 percent of your earnings get reinvested, year after year. This can help your account grow faster thanks to compounding.

You’re not avoiding taxes altogether, just delaying when you pay them. You’ll still owe income taxes when you withdraw the money.²

Getting the most of your tax breaks

To maximize your immediate tax deduction, contribute as much as you can to your retirement plan. Remember, contributions may reduce your taxable income dollar-for-dollar. Save more, pay less (in current taxes). For employer-sponsored plans that also match contributions, saving more not only helps you cut your tax bill, it also provides an immediate return on your savings by adding more money to your account. Can’t afford to save more right now? Boost your contributions gradually. Aim for one percent more each year. Even small savings increases may pay off over many years.

The key to making tax deferral really work for you is saving over many years. Start saving early in your career and continue to save and invest for as long as possible. This gives tax-deferred compounding a chance to really work. Potential account growth over 30 years can be substantially more than over 20 years. When it comes to investing, time is money.

¹ The IRS sets annual dollar limits for qualified retirement plan contributions. For 2021,the limit is $19,500 in employer-sponsored plans and $6,000 in traditional IRAs, plus catch-up amounts for both types of accounts if you're over age 50.

² Withdrawals from tax-deferred retirement plans are taxed at your ordinary income tax rate when withdrawn.