What is Tax Deferred?

by Investing School on March 28, 2011

The term “tax deferred” means that earnings on some types of investments, including interest, capital gains, or dividends, may accumulate without applied taxes up until the point in time when the investor withdraws the money and takes actual possession of the funds. The most frequently seen kinds of tax deferred investments tend to be those involved with deferred annuities and individual retirement accounts, also known as IRAs.

When an investment is able to go about deferring the taxes on its returns, there are a couple of different ways for this to be of benefit to the investor. Initially, it must be understood that deferred taxes on returns simply equates to tax-free growth! Rather than paying taxes on the increasing returns of an investment as it grows, the taxes will not fall due until a time in the future. This happy scenario allows the investment profits to continue to increase without being hampered by continuous taxation.

The other considerable benefit that an investor receives from deferred taxes comes from the fact that people will usually make investments at a time in their lives when they are making more money, which means that their income would tend to be taxed at a higher rate. The benefit, then, comes because the withdrawals from these types of retirement investment accounts occur at a time when the investor is retired and makes very little or even no other income. This leads the returns to be taxed at a significantly lower rate when the funds are to be used.

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