The Difference Between Tax Deferral and Tax Savings

Taxes influence almost every financial decision, from saving for retirement to buying a home or running a business.

Tax deferral and tax savings are common strategies for managing your tax liabilities. While they may seem interchangeable, they serve different purposes and impact your finances in unique ways. Understanding these differences is crucial for making informed decisions that align with your long-term financial goals.

In this blog, we’ll explore how tax deferral and tax savings work, their advantages and disadvantages, and how they fit into a broader financial plan.

Defining tax deferral

Tax deferral allows you to delay paying taxes on specific income until later, typically when you withdraw funds from a tax-deferred account. This approach is common in retirement accounts and certain investment strategies.

Delaying taxes to maximize growth is one of the most significant advantages of tax deferral. When you defer taxes, your investments grow tax-deferred until you withdraw them. This can lead to significant compounding over time.

For example, if you contribute to a traditional 401(k) plan, you defer paying taxes on that money until you take distributions in retirement. You may be in a lower tax bracket by then, reducing your overall tax liability. However, if tax rates increase or your income remains high in retirement, deferral may not result in lower taxes.

Common tax-deferred accounts include traditional IRAs, 401(k)s, 403(b)s, and tax-deferred annuities. These accounts allow your money to grow without annual tax payments on earnings. However, under the provisions of the SECURE Act 2.0, you must start taking required minimum distributions (RMDs) from retirement accounts beginning at age 73. The beginning age for RMDs is 75 for those who turn 74 after December 31, 2032.

This gradual increase in the age for starting RMDs allows for more flexibility in managing retirement funds and can lead to potential tax benefits by allowing your investments to grow for a more extended period before you start withdrawing.

Tax deferral in real estate investments is another example. Through a 1031 exchange, real estate investors can defer capital gains taxes by reinvesting proceeds from the sale of an investment property into another qualifying investment property. This strategy helps investors reinvest profits without immediately losing a portion to taxes.

Understand tax savings

Tax savings reduce your overall tax bill by lowering your taxable income or providing credits that directly decrease the tax owed. Unlike tax deferral, which delays tax payments, tax savings offer immediate benefits.

Reducing taxable income through deductions is one way to achieve tax savings. Tax deductions lower the income subject to taxation, reducing the overall tax burden. For example, mortgage interest, student loan interest, and charitable donations are deductible expenses that lower taxable income.

Tax credits directly reduce taxes owed and can be even more beneficial than deductions.

Tax credits provide a dollar-for-dollar reduction in the actual amount of tax due. Examples include the Child Tax Credit, the Earned Income Tax Credit (EITC), and the American Opportunity Tax Credit for education expenses.

However, many tax credits phase out at higher income levels, so eligibility varies. Check IRS guidelines to determine if you qualify.

Key differences between tax deferral and tax savings

While both strategies aim to reduce tax burdens, they operate in distinct ways and have different implications for financial planning.

One of the most notable differences is the timing of tax benefits. Tax deferral postpones taxes, allowing funds to grow before taxation. Tax savings provide immediate tax relief by reducing taxable income or offering credits.

The impact on long-term financial planning varies significantly. Tax deferral can lead to larger account balances due to compounded growth, but taxes will eventually be owed upon withdrawal. Tax savings reduce tax liability in the present, which can free up cash for spending or additional investing.

Types of applicable strategies also differ. Tax deferral is commonly associated with retirement accounts and investment gains, while tax savings are often related to deductions, credits, and business expenses.

Pros and cons of tax deferral

Tax deferral offers several advantages but has potential drawbacks that should be considered when integrating it into a financial plan.

Advantages of tax deferral include the ability to accumulate wealth more efficiently. Since taxes aren’t deducted annually from earnings, funds can compound faster.

Another advantage is the possibility of paying taxes at a lower rate in retirement. If your tax bracket decreases after you stop working, you owe less taxes than you would if you paid them earlier.

Potential drawbacks include uncertainty regarding future tax rates. If tax rates increase, you might pay more taxes than anticipated.

RMDs also pose a challenge because taking them could push you into a higher tax bracket in retirement.
A well-balanced mix of tax-deferred, tax-free (e.g., Roth accounts), and taxable accounts can help optimize tax efficiency.

Pros and cons of tax savings

Tax savings strategies can provide immediate financial benefits but also have limitations.

One of the biggest advantages is an immediate reduction in tax liability. By using deductions and credits, you can lower the taxes you owe in the current year, improving cash flow and allowing for additional investments or spending.

Limitations and eligibility requirements can be restrictive. Tax credits and deductions often come with specific eligibility criteria, requiring careful planning to maximize benefits.

Common mistakes

Misusing tax deferral and tax savings strategies can lead to financial pitfalls.

Confusing deferral with savings is a common mistake. Many assume that tax deferral equates to tax savings, but deferred taxes still need to be paid eventually. This misconception can lead to unexpected tax burdens in retirement.

Failing to plan for future tax liabilities can be costly. You might face higher tax bills later if you defer too much income without considering required distributions or future tax rates. Balancing deferred and non-deferred income sources can help manage tax exposure.

Another misstep is overlooking tax credits and deductions. Many taxpayers miss out on valuable deductions and credits simply because they are unaware of them. Keeping up with tax law changes and working with a tax professional can help identify opportunities for tax savings.

Final thoughts

Both tax deferral and tax savings play essential roles in a well-rounded financial plan. Understanding their differences helps you make strategic decisions that align with your financial goals.

Working with a tax professional and a financial advisor can provide valuable insights and help navigate the complexities of tax laws. Whether planning for retirement, managing investments, or maximizing deductions and credits, a thoughtful approach to tax planning can lead to significant financial benefits over time.