How to Get a Tax-Deferred Account

Opening a tax-deferred account is one of the most effective ways to lower your taxable income today while building wealth for tomorrow. These accounts allow your investments to grow without being taxed each year, a powerful advantage that lets your money compound more quickly. This guide will walk you through the different types of tax-deferred accounts available and provide a clear, step-by-step process for opening one.

What is a Tax-Deferred Account?

A tax-deferred account is a type of savings or investment account where you don't pay taxes on contributions or earnings until you withdraw the money, typically during retirement. The primary benefit is that you can contribute pre-tax dollars, which reduces your current adjusted gross income (AGI) and consequently lowers your annual tax bill. Because the investment earnings—like dividends, interest, or capital gains—reinvest and grow without being taxed each year, the power of compounding is amplified.

Consider this simplified example: If you're in the 24% tax bracket and contribute $6,000 to a tax-deferred account, you get to invest the full $6,000. If you were investing in a regular, taxable brokerage account, you would have to pay taxes on that $6,000 of income first, leaving you with only $4,560 to invest. The larger initial investment in the tax-deferred account, combined with its ability to grow tax-free until withdrawal, creates a significant long-term advantage.

It's important to distinguish this from tax-advantaged accounts like a Roth IRA. With a Roth, you contribute with after-tax dollars, but the growth and qualified withdrawals in retirement are completely tax-free. With a tax-deferred account, you get the tax break now, but you will pay ordinary income tax on the withdrawals later in life.

Common Types of Tax-Deferred Accounts

Tax-deferred accounts come in several forms, each designed for different situations. They generally fall into two categories: employer-sponsored plans and individual retirement arrangements.

Employer-Sponsored Plans

These are often the easiest and most effective way to start saving, especially because many employers offer a contribution match.

• 401(k) Plan: This is the most common workplace retirement plan, offered by for-profit companies. You contribute a percentage of your salary directly from your paycheck. Many employers offer a matching contribution, such as matching 100% of your contributions up to the first 3-5% of your salary. This match is essentially free money and you should always contribute enough to receive the full amount.
• 403(b) Plan: Functionally similar to a 401(k), the 403(b) is for employees of public schools, colleges, tax-exempt non-profits, and hospitals. Investment options in 403(b)s historically leaned toward annuities, but many now offer a wide range of mutual funds as well. Contribution limits are generally the same as a 401(k).
• 457(b) Plan: Offered mainly to state and local government employees, as well as some high-level executives at certain non-profits. 457(b) plans have a unique feature: employees who leave their job can withdraw funds without facing the standard 10% early withdrawal penalty that applies to 401(k)s and IRAs before age 59.5.
• SIMPLE IRA: The Savings Incentive Match Plan for Employees, or SIMPLE IRA, is designed for small businesses with fewer than 100 employees. It's less administratively burdensome than a 401(k) and requires the employer to make either matching or non-elective contributions.
• SEP IRA: The Simplified Employee Pension (SEP) IRA is a plan for self-employed individuals and small-business owners. Only the employer (or the self-employed person) makes contributions, which can be a significant percentage of an employee's compensation, up to the annual limit.

Individual Plans

If you don't have a workplace retirement plan, are self-employed, or want to save more than your employer plan allows, these are excellent options.

• Traditional IRA: A Traditional Individual Retirement Arrangement is available to anyone with earned income. You can contribute up to the annual limit set by the IRS. The key feature is the potential for tax-deductible contributions. Your ability to deduct contributions depends on whether you have a retirement plan at work and what your modified adjusted gross income (MAGI) is. If neither you nor your spouse is covered by a workplace plan, you can deduct your full contribution. If you are covered, the deduction phases out as your income increases.
• Health Savings Account (HSA): While not strictly a retirement account, an HSA is one of the most powerful tax-advantaged tools available. It offers a triple tax benefit: contributions are tax-deductible, funds grow tax-deferred, and withdrawals for qualified medical expenses are completely tax-free. To be eligible, you must be enrolled in a High-Deductible Health Plan (HDHP). After age 65, you can withdraw funds for any reason—not just medical expenses—and you’ll simply pay ordinary income tax, just like a Traditional IRA.
• Deferred Annuities: An annuity is a contract with an insurance company where you pay a premium (either lump sum or in installments) and the funds grow tax-deferred. During the "accumulation phase," your investment grows without annual taxation. In the "payout phase," you receive regular payments, and the earnings portion of each payment is taxed as ordinary income. Annuities are complex and can come with high fees and surrender charges, but they can be a useful tool for retirement savings after you have maxed out contributions to other retirement accounts.

A Step-by-Step Guide to Getting Started

Opening a tax-deferred account is a straightforward process. Here’s how to do it.

Step 1: Check With Your Employer First

Your workplace is the most logical starting point.

1. Contact HR or Your Plan Administrator: Find out which type of plan your company offers (e.g., 401(k), 403(b)) and ask for the enrollment paperwork and a summary plan description.
2. Review Plan Details: Pay close attention to the employer match rules. For example, if your employer matches 100% of contributions up to 4% of your salary, your primary goal should be to contribute at least 4% of your salary.
3. Choose Your Contribution Rate: Set up an automatic deduction from your paycheck. Even a small amount adds up over time.
4. Select Your Investments: Your plan will offer a menu of investment options, usually composed of mutual funds. Many plans offer "target-date funds," which automatically adjust their asset allocation to become more conservative as you approach your target retirement year. These can be a great, simple choice for new investors.

Step 2: Open an Individual Account if Needed

If you don't have an employer plan, are self-employed, or want to supplement your workplace savings, you'll need to open an account on your own.

1. Choose a Financial Institution: You can open an IRA at most major financial institutions. Large brokerage firms like Fidelity, Charles Schwab, and Vanguard are excellent choices, offering low fees and a wide selection of investment options. Banks also offer IRAs, but their investment choices are often limited to CDs or money market accounts with lower returns.
2. Select the Right Type of IRA: Choose the account that fits you best—Traditional IRA for tax-deferred growth, SEP or SIMPLE IRA if you're self-employed.
3. Complete the Application: Opening an account online typically takes less than 15 minutes. You'll need to provide your personal information, including your Social Security number and contact details.
4. Fund the Account: You can fund your IRA with an electronic transfer from your bank account, by mailing a check, or by executing a rollover or transfer from another retirement account.

After you fund the account, you must select your specific investments. Your money won't grow until it's invested in stocks, bonds, mutual funds, or other securities available through your broker.

Key Rules and Potential Pitfalls

Tax-deferred accounts come with specific regulations intended to encourage long-term saving for retirement.

• Contribution Limits: The IRS establishes annual contribution limits for plans like 401(k)s and IRAs. These limits can change from year to year. Be sure to check the current IRS guidelines to avoid over-contributing, which can result in penalties.
• Income Phase-Outs for Deductions: For Traditional IRAs, the ability to deduct your contributions from your taxes depends on your MAGI and whether you are covered by a workplace retirement plan. It's crucial to understand these thresholds to know whether your contribution will actually lower your tax bill.
• Early Withdrawal Penalties: If you withdraw money from most tax-deferred retirement accounts before age 59.5, you will likely owe a 10% penalty on top of the regular income tax. There are exceptions for specific circumstances like disability, a first-time home purchase (from an IRA), or certain medical expenses.
• Required Minimum Distributions (RMDs): The IRS mandates that you must begin taking withdrawals—known as RMDs—from most tax-deferred accounts (including Traditional IRAs and 401(k)s) starting at age 73. The RMD amount is calculated based on your account balance and life expectancy. Failure to take your full RMD results in a substantial penalty.

Final Thoughts

In short, starting a tax-deferred savings plan is a foundational step in securing your financial future. Whether it's through a workplace 401(k) or a Traditional IRA you open yourself, these accounts provide an immediate tax benefit and accelerate your wealth accumulation through the power of compounded, untaxed growth.

As you manage your retirement account contributions or advise clients on topics like MAGI phase-outs and RMD calculations, having precise, accurate information is essential. Instant answers backed by official sources can save valuable time, ensuring compliance and maximizing tax advantages. We built Feather AI to provide tax professionals with immediate, citation-backed answers for exactly these types of complex scenarios, turning hours of manual research into seconds.