What Is a Tax-Deferred Retirement Account?

Tax-deferred retirement accounts, such as 401(k)s and traditional IRAs, offer a tax-friendly way to save for the future. These accounts allow you to make tax-deductible contributions, and your funds grow tax-free until you make withdrawals. At that point, your withdrawals are taxed as ordinary income, based on your tax bracket.

Pros and Cons of Tax-Deferred Retirement Accounts

Pros

• Tax-deductible contributions: Reduce your taxable income and potentially lower your tax bracket.
• Tax-free growth: No taxes on dividends, interest, or capital gains until withdrawal.
• Potential employer match: Many employers match contributions to 401(k) plans, adding to your savings.

Cons

• Contribution limits: In 2023, 401(k) contributions are capped at $22,500, and IRA contributions at $6,500.
• Early withdrawal penalties: Withdrawals before age 59½ may incur a 10% penalty.
• Required Minimum Distributions (RMDs): Mandatory withdrawals starting at age 73, with penalties for non-compliance.

Tax-Deferred vs. Tax-Exempt Retirement Accounts

Tax-deferred accounts delay taxes until withdrawal, while tax-exempt accounts, like Roth IRAs, are funded with after-tax dollars. Roth IRAs allow tax-free withdrawals of contributions at any time, with no RMDs, but contributions are not tax-deductible.

3 Types of Tax-Deferred Accounts

Traditional 401(k)

An employer-sponsored plan funded through payroll deductions. Self-employed individuals can opt for a solo 401(k) for similar benefits.

Traditional IRA

Available through brokerage firms, these accounts offer lower contribution limits but are a good supplement to your retirement savings.

Health Savings Account (HSA)

Designed for those with high-deductible health plans, HSAs offer tax-free withdrawals for qualified medical expenses. Contribution limits for 2023 are $3,850 for individuals and $7,750 for families.

The Bottom Line

Tax-deferred retirement accounts provide significant tax benefits, but they come with contribution limits, early withdrawal penalties, and RMDs. As you plan for retirement, consider these factors to determine if tax-deferred accounts are right for you.

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