What Is One Type of Deferred Tax Investment Account?
Discover how a popular deferred tax investment account works, its tax benefits, and practical steps for optimizing your long-term savings strategy.
A deferred tax investment account allows individuals to save and invest money for future goals, typically retirement, while postponing the payment of taxes on those funds. This means that either contributions made to the account may be tax-deductible in the current year, or the investment earnings within the account grow without being taxed annually. Taxes are instead paid at a later date, usually upon withdrawal during retirement. These accounts encourage long-term savings by providing tax advantages that can enhance investment growth over time.
Understanding the Traditional IRA
The Traditional Individual Retirement Arrangement, widely known as a Traditional IRA, is a common deferred tax investment account. Its purpose is to help individuals save for retirement with potential tax benefits. Anyone with earned income can contribute, regardless of age, up to their earned income for the year. Spouses who do not work can also contribute to a spousal IRA if their working spouse earns enough to cover the contribution.
For 2025, the annual contribution limit for a Traditional IRA is $7,000 for individuals under age 50. Those aged 50 and over can make an additional $1,000 “catch-up” contribution, bringing their total annual limit to $8,000. These limits apply to total contributions across all Traditional and Roth IRAs combined. Contributions for a tax year can be made until the unextended federal tax deadline of the following year.
Tax Mechanics of the Traditional IRA
Contributions to a Traditional IRA may be tax-deductible in the year they are made, which can reduce an individual’s current taxable income. Deductibility depends on whether the individual (or their spouse, if married) is covered by a retirement plan at work and their modified adjusted gross income (MAGI). In 2025, a single taxpayer covered by a workplace plan may have a full deduction if their MAGI is $79,000 or less, a partial deduction between $79,000 and $89,000, and no deduction if their MAGI is $89,000 or more.
If neither the individual nor their spouse is covered by a workplace retirement plan, contributions are fully deductible regardless of income. For married couples filing jointly where one spouse is covered by a workplace plan, the deduction may be phased out for MAGI between $126,000 and $146,000 in 2025. If an IRA contributor is not covered by a workplace plan but is married to someone who is, the phase-out range for deductibility in 2025 is between $236,000 and $246,000.
Investments within a Traditional IRA grow on a tax-deferred basis; earnings like interest, dividends, and capital gains are not taxed annually. This allows investments to compound more efficiently, as taxes are postponed until withdrawals. Upon retirement, distributions are generally taxed as ordinary income, subject to the same tax rates as wages or salaries.
Required Minimum Distributions (RMDs) are mandatory withdrawals Traditional IRA owners must begin taking at a certain age to prevent indefinite tax deferral. For individuals born between 1951 and 1959, RMDs generally begin at age 73. The first RMD must be taken by April 1 of the year following the year the individual reaches the RMD age. Subsequent RMDs must be taken by December 31 annually. Failure to take the full RMD amount by the deadline can result in a 25% penalty.
Practical Aspects of a Traditional IRA
Opening a Traditional IRA is offered by various financial institutions, including banks, brokerage firms, or mutual fund companies. The process involves completing an application and funding the account, often through electronic transfers or check deposits.
Once established, a Traditional IRA can hold a diverse range of investments. Common options include stocks, bonds, mutual funds, exchange-traded funds (ETFs), and certificates of deposit (CDs). Investment choices depend on the financial institution where the IRA is held.
Traditional IRAs are frequently used for rolling over funds from employer-sponsored retirement plans, such as a 401(k) or 403(b), when changing jobs or retiring. This rollover process allows funds to maintain their tax-deferred status without immediate taxes or penalties. Direct rollovers, transferring funds directly from one custodian to another, are recommended to avoid potential withholding or missteps. This strategy provides individuals with greater control and a broader selection of investment options.