What is tax deferral?
Tax deferral is when taxpayers delay paying taxes to some point in the future. Some taxes can be deferred indefinitely, while others may be taxed at a lower rate in the future. Individual taxpayers and corporations may defer certain taxes; retaining corporate profits overseas is also a form of tax deferral.
To defer taxes on earnings, an individual taxpayer must place funds into a retirement account. If the taxpayer withdraws the funds before the age of 59.5, he or she incurs an early withdrawal penalty of 10 percent of the total withdrawn. Earnings in the account withdrawn after this age threshold are taxed at a more favorable rate.
There are seven tax-deferred retirement accounts available to individual taxpayers:
- 401(k) or 403(b): These accounts are offered by employers, who often match funds deposited by employees, up to a certain amount.
- Solo 401(k): Owners of sole-proprietor businesses can set up their own 401(k) accounts and make contributions as both an employer and employee.
- Individual Retirement Account (IRA): This standard individual retirement account allows you to save up to a certain amount every year.
- Simple IRA: A simple IRA is used by employers with less than 100 employees and requires less paperwork than a standard IRA.
- SEP IRA: Small businesses and self-employed workers can use a simplified employee pension to save for retirement.
- Roth IRA: This account lets you to save up to a certain amount of your after-tax dollars each year. Contributions cannot be deducted from taxes.
- Health savings account: These accounts let individuals save pre-tax funds to pay medical expenses.
Corporations can defer taxes using accelerated depreciation. Under this approach, taxes are reduced in the present by recognizing less revenue or by increasing expenses. This has the effect of shifting tax payment to future periods. Taxes on profits earned in foreign countries are commonly deferred by reinvesting or leaving the profits overseas.
Tax deferral example
Philip had accumulated $100,000 in his IRA by 2015, and the account earned $10,000 in 2016. He did not owe any taxes on the $10,000 gain; instead, Philip will pay taxes on earnings when he withdraws funds from the IRA decades from now.
Philip was in a 33 percent tax bracket and would have had to pay $3,333 in taxes on the $10,000 earned in 2016 if it had not been in a tax-deferred account — which would have reduced the net gain to $6,667. Because IRAs are tax-deferred, Philip harvested a return on the full $10,000 rather than the notional after-tax $6,667. The advantages of tax deferral compound year after year.