Tax deferral means postponing income tax that would otherwise be due on employment or investment earnings until some point in the future, often when you retire. For example, you can contribute pretax income to employer sponsored retirement plans, such as a 401(k) or 403(b). You owe no tax on any earnings in these plans, or in traditional individual retirement accounts (IRAs), fixed and variable annuities, and some insurance policies until you withdraw the money. Then tax is due on the amounts you take out, at the same rate you pay on your regular income.
A big advantage of tax deferral is that earnings may compound more quickly, since no money is being taken out of the account to pay taxes. But in return for postponing taxes, you agree to limited access to your money before you reach 59½.
Some investments are tax exempt, which means you don't have to pay income tax on the earnings they produce. For example, the interest you receive on a municipal bond is generally exempt from federal income tax, and also exempt from state and local income tax if you live in the state where the bond was issued. However, if you sell the bond before maturity, any capital gain is taxable.
Similarly, dividends on bond mutual funds that invest in municipal bonds are exempt from federal income tax. And for residents of the issuing state for single-state funds, the dividends are also exempt from state and local taxes. Capital gains on these funds are never tax exempt.
Earnings in a Roth IRA are tax exempt when you withdraw them, provided your account has been open for five years or more and you're at least 59½ years old. And earnings in 529 college savings plans and Coverdell education savings accounts (ESAs) are also tax exempt if the money is used to pay qualified education expenses.
When an organization such as a religious, educational, or charitable institution, or other not-for-profit group, is tax-exempt, it does not owe tax of any kind to federal, state, and local governments. In addition, you can take an income tax deduction for gifts you make to such organizations.
A term is the length of time between when a fixed-income security, such as a bond or note, is offered for sale and its maturity date. When the term ends, the issuer repays the par value of the security, often along with the final interest payment. In general, the longer the term, the higher the rate of interest the investment pays, to offset the increased risk of tying up your money for a longer period of time.
Term is also the lifespan of a certificate of deposit (CD), called a time deposit. If you hold a CD for the entire term, which may run from six months to five years, you collect the full amount of interest the CD has paid during the term and are free to roll the principal into a new CD or use the money for something else.