What Is Tax-Deferred Income and How Is It Taxed?

Tax-deferred income is money you earn or gain that you don’t pay income tax on in the year you receive it, because it sits inside a qualifying retirement account or annuity contract. The tax doesn’t disappear; it waits. When you eventually pull the money out, usually in retirement, you pay ordinary income tax on it at whatever rate applies to you that year. In the meantime, dividends, interest, and investment gains inside the account compound without an annual tax bill.¹

Where Tax-Deferred Income Comes From

Most tax-deferred income runs through an employer-sponsored retirement plan. A 401(k) lets private-sector employees redirect part of a paycheck before income taxes are calculated on it. A 403(b) does the same job for employees of public schools and certain nonprofits, and a governmental 457(b) does it for state and local government workers. The structure is the same across all three: money in before tax, growth without annual tax, tax owed on withdrawal.¹

You can also open a traditional IRA on your own and defer income that way, whether or not you have a workplace plan. Qualified annuities work on the same principle: you contract with an insurance company, the account accumulates interest untaxed, and reporting doesn’t begin until payments start.

How the Tax Actually Hits

When you take money out, it is taxed as ordinary income, not at the lower long-term capital gains rates. That matters. A stock held in a taxable brokerage account for a year and a day gets favorable capital gains treatment; the same stock sold inside a traditional 401(k) doesn’t. Every dollar coming out is treated like wages. A large single-year withdrawal can push you into a higher bracket than you expected.

Tax-Deferred Is Not Tax-Free

This is where searchers often get tangled. A traditional 401(k) or traditional IRA is tax-deferred: deduction now, tax later. A Roth 401(k) or Roth IRA is tax-exempt on the back end: no deduction now, but qualified withdrawals in retirement come out completely tax-free.²

The choice usually turns on whether you expect your tax rate to be higher now or in retirement. Lower later favors the traditional deferral. Higher later favors paying tax now through a Roth. Many people split contributions between the two.

How Much You Can Defer in 2026

The IRS caps annual deferrals so the shelter can’t be used without limit. For 2026, the elective deferral limit for 401(k), 403(b), governmental 457(b), and Thrift Savings Plans is $24,500. The IRA contribution limit is $7,500.³

Older workers can add catch-up contributions on top of those base limits for 2026:

Age 50 and over in a 401(k), 403(b), or 457(b): an extra $8,000, bringing the total to $32,500.
Ages 60 through 63 in a 401(k), 403(b), or 457(b): an enhanced catch-up of $11,250, bringing the total to $35,750. This higher band is a SECURE Act 2.0 provision that first took effect in 2025.
Age 50 and over in an IRA: an extra $1,100, bringing the total to $8,600.

All of those figures come from the IRS cost-of-living adjustments announced for 2026.⁴

One quirk: if you participate in both a 403(b) and a governmental 457(b) through the same employer, each plan carries its own separate deferral limit. You could defer $24,500 in each, for $49,000 total. The 457(b) limit does not stack with a 401(k) or 403(b) limit.⁵

Starting in 2026, if you earned $150,000 or more in FICA-taxable wages the prior year, any catch-up contribution you make to a 401(k), 403(b), or governmental 457(b) must go in on an after-tax Roth basis. If your workplace plan doesn’t offer a Roth option, you won’t be able to make catch-up contributions at all under this SECURE Act 2.0 rule.

Contribute more than the annual limit and you’ll owe a 6% excise tax on the excess for each year it stays in the account.⁶ The fix is to withdraw the excess, along with any earnings on it, before your tax filing deadline for that year.

A Note on IRA Deductibility

Anyone with earned income can contribute to a traditional IRA, but whether the contribution is actually deductible depends on your income and whether you or your spouse are covered by a workplace plan. If neither of you is covered, the full deduction is available regardless of income. If you are covered, the deduction phases out over defined income ranges published by the IRS for 2026.⁴ Even when your income is too high for a deduction, you can still make a nondeductible IRA contribution. If you do, file Form 8606 to track the after-tax basis so you aren’t taxed twice on that money later.⁷

What Happens if You Withdraw Early

Take money out of a tax-deferred account before age 59½ and you owe a 10% additional tax on top of the regular income tax on the withdrawal.⁸ On a $50,000 early withdrawal, that’s a $5,000 penalty before income tax is even calculated. For SIMPLE IRAs, the penalty jumps to 25% if you pull money out within the first two years of participating.⁹

Several situations remove the 10% penalty, though ordinary income tax still applies to the withdrawal:

Total and permanent disability of the account owner.
Substantially equal periodic payments taken over your life expectancy.
Unreimbursed medical expenses above 7.5% of adjusted gross income.
Qualified higher education expenses (IRAs only).
First-time homebuyer costs up to $10,000 (IRAs only).
Birth or adoption expenses up to $5,000 per child.
Separation from service during or after the year you turn 55, or 50 for public safety employees (employer plans only).
Federally declared disaster losses up to $22,000.
Terminal illness certified by a physician.

Some exceptions apply only to IRAs, others only to employer plans, so check the specific rules for the account you’re drawing from before you withdraw.⁹

When Deferral Has to End

Tax-deferred accounts can’t stay deferred indefinitely. Once you reach age 73, you must begin taking required minimum distributions each year from your traditional IRAs, 401(k)s, 403(b)s, and similar accounts. For people born in 1960 or later, the starting age is 75. Your first RMD is due by April 1 of the year after you turn 73; every RMD after that is due by December 31.¹⁰

Delaying that first RMD to April 1 sounds convenient, but it means taking two distributions in the same calendar year, which can inflate that year’s tax bill.

The annual amount is calculated by dividing your account balance on December 31 of the prior year by a life expectancy factor from IRS tables. If you have multiple traditional IRAs, each one’s RMD is calculated separately, but you can take the total from any one or any combination of them. Employer-plan RMDs generally must come from each plan individually.

Miss an RMD and the excise tax on the shortfall is 25%. Correct the miss within two years by withdrawing the shortfall and filing the right return, and the penalty drops to 10%.¹¹ Roth IRAs are exempt from RMDs during the owner’s lifetime.

How Tax-Deferred Income Shows Up on Your Return

Three forms carry most of the information. Form W-2, Box 12 shows how much you deferred through a workplace plan during the year, with a letter code identifying the plan type.¹² Form 1099-R reports distributions: Box 1 is the gross amount, Box 2a is the taxable portion, and Box 7 carries a distribution code that tells the IRS the nature of the withdrawal. Code 1 flags an early distribution with no known exception (likely hit with the 10% penalty); Code 7 signals a normal distribution after 59½.¹³ A wrong code can trigger an incorrect penalty notice, so check it against what actually happened.

Form 5498 reports IRA contributions, rollovers, and year-end account value.¹⁴ It isn’t due until May 31 of the following year because IRA contributions can be made up through the filing deadline.

On Form 1040 itself, retirement distributions go on line 4a (total) and line 4b (taxable). If part of a distribution was a return of after-tax contributions, line 4b is lower than 4a. IRA deductions for the year go on Schedule 1, line 20, and flow into the adjusted gross income calculation on line 11 of the 1040.¹⁵ Because the deduction reduces AGI directly, it can also affect eligibility for other tax benefits that phase out at higher income levels.

If you made nondeductible IRA contributions, file Form 8606 to establish and carry forward your after-tax basis. Skipping it is a common mistake and creates real trouble years later when you can’t prove which portion of a withdrawal was already taxed.⁷

1
Internal Revenue Service. Traditional IRAs
2
Internal Revenue Service. Traditional and Roth IRAs
3
Internal Revenue Service. 401(k) Limit Increases to $24,500 for 2026, IRA Limit Increases to $7,500
4
Internal Revenue Service. 2026 Amounts Relating to Retirement Plans and IRAs
5
Internal Revenue Service. How Much Salary Can You Defer if Youre Eligible for More Than One Retirement Plan
6
Office of the Law Revision Counsel. 26 USC 4973 – Tax on Excess Contributions to Certain Tax-Favored Accounts and Annuities
7
Internal Revenue Service. 2025 Instructions for Form 8606
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Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
9
Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
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Internal Revenue Service. Retirement Topics – Required Minimum Distributions (RMDs)
11
Office of the Law Revision Counsel. 26 USC 4974 – Excise Tax on Certain Accumulations in Qualified Retirement Plans
12
Internal Revenue Service. Instructions for Forms W-2 and W-3 – Box 12 Codes
13
Internal Revenue Service. Instructions for Forms 1099-R and 5498
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Internal Revenue Service. Form 5498 – IRA Contribution Information
15
Internal Revenue Service. Schedule 1 (Form 1040) – Adjustments to Income