Deferring Taxes Until Retirement: How It Works

Tax deferral is a financial strategy that postpones income taxes on savings and investments until retirement. This allows investments to grow over many years without being reduced by annual tax payments. By delaying taxes, you can invest the full amount of your contributions and earnings, which helps your money compound more effectively during your working life.

The Mechanics of Tax Deferral

The strategy begins by contributing money to a designated retirement account on a pre-tax basis. This action reduces your taxable income for the current year, which can lower your immediate tax bill. For example, if you earn $70,000 and contribute $6,000 to a tax-deferred plan, your taxable income is lowered to $64,000.

A major advantage is the tax-deferred growth of the investments within the account. Any interest, dividends, or capital gains are not subject to annual taxes. This is different from a standard brokerage account, where earnings are taxed each year, creating a “tax drag” that can slow investment growth. Allowing all earnings to be reinvested enhances the power of compounding over time.

Taxation occurs when you withdraw money from the account, usually after reaching retirement age. All withdrawn funds, including original contributions and accumulated earnings, are taxed as ordinary income. The expectation is that many people will be in a lower tax bracket during retirement compared to their peak earning years, potentially resulting in a lower overall tax bill.

Employer-Sponsored Retirement Plans

Many employers offer retirement plans with tax-deferral benefits to help employees save for the future. The structure of these plans can vary, but they all share the goal of postponing taxes on savings.

401(k) Plans

The 401(k) plan is offered by many for-profit companies. Employees can defer a portion of their salary into the account on a pre-tax basis, lowering their current taxable income. For 2025, the IRS allows employees to contribute up to $23,500. Individuals aged 50 and over can make additional “catch-up” contributions of $7,500, for a total of $31,000.

Many 401(k) plans feature an employer match, where companies match a percentage of an employee’s contributions. The total combined contributions from both the employee and employer cannot exceed $70,000 in 2025, or $77,500 for those making catch-up contributions.

The SECURE 2.0 Act introduced a provision effective in 2025 for those approaching retirement. Individuals aged 60 through 63 may be able to make a higher catch-up contribution of $11,250, if their plan allows it. This would permit a total contribution of $34,750 for participants in this age range.

403(b) Plans

Functionally similar to 401(k)s, 403(b) plans are for employees of public schools, certain 501(c)(3) non-profit organizations, and religious institutions. Contributions are made with pre-tax dollars, and the investments grow tax-deferred.

The contribution limits for 403(b) plans mirror those of 401(k)s. For 2025, the employee deferral limit is $23,500. These plans also allow for the same catch-up contributions, including the standard $7,500 for those 50 and over and the higher $11,250 amount for those aged 60 to 63, if the plan adopts the provision.

457(b) Plans

State and local government employees are often eligible for 457(b) deferred compensation plans. These plans allow participants to set aside a portion of their salary on a pre-tax basis, with funds growing tax-deferred. The contribution limits and catch-up provisions are the same as those for 401(k) plans.

If an employer offers both a 403(b) and a 457(b) plan, an eligible employee may be able to contribute the maximum to both plans, potentially deferring up to $47,000 in 2025. Another difference is that withdrawals from a governmental 457(b) plan after separation from service are not subject to the 10% early withdrawal penalty, regardless of age.

Individual Retirement Arrangements (IRAs)

Individuals can also save for retirement through Individual Retirement Arrangements, or IRAs. These accounts are established by individuals and offer tax advantages to encourage saving.

Traditional IRA

A Traditional IRA is an account that anyone with earned income can contribute to. For 2025, the maximum contribution is $7,000, with an additional $1,000 catch-up contribution for those aged 50 and older. The main feature of a Traditional IRA is the potential for tax-deductible contributions.

The ability to deduct contributions depends on your income and whether you or your spouse are covered by a retirement plan at work. If neither has a workplace plan, you can deduct your full contribution. If you are covered by a workplace plan, your deduction may be limited based on your modified adjusted gross income (MAGI). For 2025, the deduction for a single filer with a workplace plan phases out with a MAGI between $79,000 and $89,000.

SEP IRA

The Simplified Employee Pension (SEP) IRA is a plan for self-employed individuals and small business owners. It allows for larger contributions than a Traditional IRA. For 2025, an employer can contribute up to 25% of an employee’s compensation, not to exceed $70,000.

Contributions to a SEP IRA are made only by the employer; employees do not make salary deferrals. For a self-employed person, the business makes the contribution on their behalf. If a contribution is made for a year, it must be the same percentage of compensation for all eligible employees.

SIMPLE IRA

The Savings Incentive Match Plan for Employees (SIMPLE) IRA is an option for small businesses with 100 or fewer employees. For 2025, employees can contribute up to $16,500 from their salary. Those aged 50 and over can make an additional catch-up contribution of $3,500.

Employers are required to make contributions each year. They can choose a matching contribution, up to 3% of the employee’s compensation, or a non-elective contribution of 2% of compensation for each eligible employee. The SECURE 2.0 Act also allows for a higher catch-up limit of $5,250 for participants aged 60 to 63, beginning in 2025.

Taxation and Withdrawals in Retirement

The rules governing withdrawals are structured to ensure that taxes are eventually paid and that the funds are used for retirement income.

Ordinary Income Tax Treatment

When you take distributions from tax-deferred accounts like traditional 401(k)s and Traditional IRAs, the entire amount is treated as ordinary income. The money is taxed at your personal income tax rate for the year you receive it. This applies to both your pre-tax contributions and all accumulated investment earnings.

Required Minimum Distributions (RMDs)

The government requires you to start taking withdrawals from your tax-deferred retirement accounts to ensure it can collect the deferred taxes. These are known as Required Minimum Distributions (RMDs). Under rules from the SECURE 2.0 Act, you must begin taking RMDs for the year you reach age 73.

You can delay your first RMD until April 1 of the year after you turn 73, but you will then have to take your second RMD by December 31 of that same year. RMDs apply to 401(k)s, 403(b)s, 457(b)s, and Traditional, SEP, and SIMPLE IRAs. Failing to take the full RMD amount results in a 25% penalty on the amount not withdrawn, which can be reduced to 10% if corrected in a timely manner.

Early Withdrawal Penalties

These accounts are designed for long-term savings. If you withdraw money from a tax-deferred account before age 59½, the withdrawal is subject to a 10% penalty tax in addition to regular income tax. For SIMPLE IRAs, this penalty can be 25% if the withdrawal is within the first two years of participation.

The IRS allows for several exceptions to the 10% penalty, including withdrawals for:

• Total and permanent disability
• Certain unreimbursed medical expenses exceeding 7.5% of your adjusted gross income
• Qualified higher education expenses
• A lifetime limit of $10,000 for a first-time home purchase
• Up to $5,000 for expenses related to a qualified birth or adoption