Tax-Deferred
Tax-Deferred
Investment earnings (interest, dividends, capital gains) that grow without current taxation until withdrawn. Common examples: Traditional IRA, 401(k), 403(b), 457 plans, and annuities. Contributions may be pre-tax (Traditional IRA, 401k) or after-tax (annuities, non-deductible IRA). Distributions taxed as ordinary income. Required Minimum Distributions (RMDs) begin at age 73 for most accounts.
A 45-year-old client contributes $6,500 annually to a Traditional IRA (pre-tax). Over 20 years, the account grows from $0 to $250,000 through contributions and investment gains, with zero taxes paid during growth. At age 65, withdrawals are taxed as ordinary income. If the client is in the 22% bracket at retirement, each $10,000 withdrawal incurs $2,200 in taxes. Tax deferral allowed decades of compounding without annual tax drag.
Students often confuse tax-deferred with tax-free (Roth accounts are tax-free; Traditional accounts are tax-deferred). Another common error: thinking all withdrawals are taxed (only the gains are taxed in after-tax annuities; everything is taxed in pre-tax retirement accounts). Critical distinction: tax-deferred means postponed taxation, not eliminated taxation. Distributions are taxed at ordinary income rates, not capital gains rates.
How This Is Tested
- Distinguishing between tax-deferred (Traditional IRA) and tax-free (Roth IRA) account treatment
- Identifying which investment vehicles offer tax-deferred growth (401k, Traditional IRA, annuities)
- Understanding that tax-deferred distributions are taxed as ordinary income, not capital gains
- Calculating the tax impact of withdrawals from tax-deferred accounts based on client tax bracket
- Determining when RMDs are required for tax-deferred retirement accounts (age 73)
Regulatory Limits
| Description | Limit | Notes |
|---|---|---|
| RMD starting age | Age 73 | For individuals who turn 72 after December 31, 2022 (SECURE 2.0 Act) |
| Early withdrawal penalty | 10% penalty | IRS penalty on distributions before age 59½ (with certain exceptions) |
Example Exam Questions
Test your understanding with these practice questions. Select an answer to see the explanation.
Jennifer, a 35-year-old software engineer earning $120,000 annually, is deciding between contributing to a Traditional 401(k) (tax-deferred) or a Roth 401(k) (tax-free). She is currently in the 24% tax bracket and expects to be in the 12% bracket at retirement due to lower income needs. She plans to retire at age 65. Which account type would provide the greatest tax advantage?
A is correct. Jennifer benefits from the tax arbitrage: she deducts contributions at her current 24% rate and will pay taxes at the lower 12% rate in retirement. This 12-percentage-point spread creates significant value. With a 30-year time horizon, the upfront tax savings (24% deduction) invested alongside her contributions will outweigh the tax cost at withdrawal (12%).
B is incorrect because tax-free is not always better when current tax rates exceed future rates. The immediate 24% deduction provides more capital to invest. C is incorrect because tax-deferred and tax-free accounts compound at the same rate; the difference is the timing and rate of taxation. D is partially true (Roth 401(k)s have no RMDs after rollover to Roth IRA), but this benefit is outweighed by the unfavorable tax arbitrage in her situation (paying 24% now instead of 12% later).
The Series 65 exam tests your ability to analyze tax-deferred vs. tax-free account suitability based on current vs. expected future tax rates. Understanding tax arbitrage (saving at high rate, paying at low rate) is critical for retirement planning recommendations. This is one of the most common suitability questions on the exam.
Which of the following investment accounts provides tax-deferred growth, where earnings are not taxed until withdrawal?
B is correct. Traditional IRAs provide tax-deferred growth, meaning investment earnings (interest, dividends, capital gains) are not taxed annually but are taxed as ordinary income upon withdrawal. This allows decades of compounding without tax drag during the accumulation phase.
A (Roth IRA) is incorrect because it provides tax-free growth, not tax-deferred. Qualified withdrawals from Roth IRAs are entirely tax-free. C (taxable brokerage account) is incorrect because earnings are taxed annually (dividends, interest, realized capital gains). D (municipal bond fund in taxable account) provides tax-exempt interest income but capital gains are still taxable, and it does not defer taxes.
The Series 65 exam frequently tests the distinction between tax-deferred (Traditional IRA, 401k), tax-free (Roth IRA), and taxable accounts. Investment advisers must understand which accounts offer tax deferral to properly structure retirement savings strategies and explain trade-offs to clients.
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C is correct. The entire $50,000 withdrawal is taxed as ordinary income at her 22% tax bracket: $50,000 × 22% = $11,000. In a Traditional IRA with pre-tax contributions, both the original contributions AND the gains are taxed upon withdrawal because the contributions were never taxed initially.
A is incorrect because penalty-free (after age 59½) does not mean tax-free. Withdrawals from Traditional IRAs are always taxed as ordinary income. B incorrectly assumes only the gain portion is taxed, which would apply to after-tax (non-deductible) IRA contributions, but this scenario specifies all contributions were pre-tax. D is incorrect because Traditional IRA distributions are taxed at ordinary income rates, never capital gains rates, regardless of how the money was invested.
Understanding tax treatment of tax-deferred account distributions is critical for the Series 65 exam. Advisers must explain to clients that all Traditional IRA withdrawals (both contributions and gains) are taxed as ordinary income, and penalty-free does not mean tax-free. This affects withdrawal strategies and retirement income planning.
All of the following statements about tax-deferred accounts are accurate EXCEPT
C is correct (the EXCEPT answer). Tax-deferred accounts do NOT eliminate taxation; they postpone it. Distributions are eventually taxed as ordinary income, regardless of the account holder's age. The term "tax-deferred" means "tax postponed," not "tax eliminated."
A is accurate: tax-deferred accounts allow earnings (interest, dividends, capital gains) to grow without annual taxation during the accumulation phase, maximizing compounding. B is accurate: all distributions from Traditional IRAs, 401(k)s, and similar tax-deferred accounts are taxed as ordinary income rates (10%-37%), not at preferential capital gains rates (0%-20%). D is accurate: Traditional IRAs, 401(k)s, 403(b)s, 457 plans, and deferred annuities are all common tax-deferred investment vehicles.
The Series 65 exam tests the critical distinction between tax-deferred (postponed taxation) and tax-free (eliminated taxation like Roth accounts). Students often confuse penalty-free withdrawals after 59½ with tax-free withdrawals. Understanding this difference is essential for proper retirement account recommendations and client education.
A 50-year-old client asks about the benefits of contributing to a Traditional 401(k) plan (tax-deferred) versus a taxable brokerage account. Which of the following statements accurately describe advantages of the tax-deferred 401(k)?
1. Contributions reduce current taxable income
2. Investment gains compound without annual tax drag
3. Withdrawals in retirement are tax-free if held for 5+ years
4. No 10% early withdrawal penalty after age 59½
B is correct. Statements 1, 2, and 4 are accurate advantages of tax-deferred 401(k) plans.
Statement 1 is TRUE: Traditional 401(k) contributions are made with pre-tax dollars, reducing current taxable income. A $10,000 contribution reduces taxable income by $10,000, providing an immediate tax deduction.
Statement 2 is TRUE: Investment gains in a 401(k) compound without annual taxation. Unlike a taxable brokerage account where dividends, interest, and realized capital gains are taxed each year, the 401(k) allows decades of tax-free compounding, maximizing growth.
Statement 3 is FALSE: Withdrawals from Traditional 401(k)s are NEVER tax-free. All distributions are taxed as ordinary income, regardless of holding period. This statement confuses tax-deferred (Traditional 401k) with tax-free (Roth 401k) treatment.
Statement 4 is TRUE: After age 59½, withdrawals from a 401(k) do not incur the 10% early withdrawal penalty (though distributions are still taxed as ordinary income). Before age 59½, most withdrawals trigger the penalty unless an exception applies.
The Series 65 exam tests comprehensive understanding of tax-deferred account benefits and limitations. You must distinguish between tax deferral (postponed taxation), penalty-free withdrawals (age-based), and tax-free treatment (Roth accounts only). This multi-factor analysis is essential for evaluating 401(k) vs. taxable account suitability and providing accurate client guidance.
💡 Memory Aid
Think of tax-deferred as "Pay Me Later": The IRS says "I'll wait" while your money grows, but eventually you must pay ordinary income tax on withdrawals. Compare to Roth (tax-free) = "Pay Me Now, Never Again" (taxed contributions, tax-free growth). Remember: Deferred ≠ Deleted. The tax bill is postponed, not eliminated.
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Where This Appears on the Exam
This term is tested in the following Series 65 exam topics: