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What are Deferred Savings Plans?

A tax-deferred savings account is a type of investment that enables a taxpayer to avoid paying taxes on invested funds until the funds are taken in retirement.

  • Jul 25, 2022
  • 2,908 Views

There are a lot of ways in which an individual can save taxes today. However, investing in policies that offer both insurance and investments can help you save taxes and make them more valuable. To save your taxes while keeping your money invested, you have options like Unit Linked Insurance Plans (ULIPs) or traditional schemes. But, one of the best ways to do it is by opting for a tax-deferred savings plan.

Many people are unaware of such a scheme and how a tax-deferred savings plan works. This article will tell you all about tax-deferred savings plans and the tax-deferred options that you can opt for. But before we move on to discuss the tax-deferred savings plan, let’s understand its definition and purpose.

What is a Tax-Deferred Savings Plan?

A tax-deferred savings plan is an investment option that allows investors to postpone the payment of taxes on the money invested until it is withdrawn. Mostly, people use this option for post-retirement income. It is a long-term investment tool and comes with multiple benefits. This financial plan comes in indexed, variable, and fixed. Based on the type of plan that an investor opts for, the computation of different rates and returns takes place. Therefore, this plan can be considered as an insurance contract that does not provide a return in the short term but is highly beneficial, specifically as a long-term investment option.

A tax-deferred savings plan is an investment option that allows investors to postpone the payment of taxes on the money invested until it is withdrawn. Mostly, people use this option for post-retirement income. It is a long-term investment tool and comes with multiple benefits. This financial plan comes in indexed, variable, and fixed. Based on the type of plan that an investor opts for, the computation of different rates and returns takes place. Therefore, this plan can be considered as an insurance contract that does not provide a return in the short term but is highly beneficial, specifically as a long-term investment option.

As its name suggests, an investor of a tax-deferred savings plan can delay the payments indefinitely. During this time, the earnings made on the plan are tax-deferred, and the tax will be charged only at the time of withdrawal and post-completion of the policy period.

However, before investing in a tax-deferred savings plan, you must ensure that you can carry out this investment for the long term and the minimum given period of the plan. Failing to continue may result in withdrawal from the plan, and you may have to pay a tax penalty and surrender charges.

How Does a Tax-Deferred Savings Plan Work?

The working of a tax-deferred savings plan may sound a bit technical but is quite simple. To understand this, you have to divide the plan into two phases.

Accumulation Phase

Accumulation phase: When as an investor, you invest money into a plan to bulk up your savings and earn tax-free interest on it

Payout Phase

Payout Phase: In this phase of the tax-deferred savings plan, the policyholder gets the payment in a withdrawal, lump sum amount or a regular income. These payments are taxable as per the current income tax slab that the individual falls in.

Tax Deferred Savings Plan Lock-In Period, Tax Penalty, And Charges

Generally, these plans are locked in for up to 59.5 years, and you are in the accumulation phase until this time. If you withdraw the money from tax-deferred plans before this period, then you will have to pay a 10% tax penalty on the amount withdrawn above your average tax slab rate that you already have to pay on your withdrawal.

Types of Charges levied on tax-deferred savings plans

Certain charges are levied on the tax-deferred plans that, as an investor, you should know.

1. Income tax

Income tax is charged on the tax-deferred savings plans as and when you withdraw the money as per your current income tax slab in India. So when you withdraw the money after the maturity of the plan, then you will be charged as per your post-retirement income tax slab. However, if you withdraw the money before your retirement age, then you will have to pay tax on the total amount as per your current income tax slab.

2. Surrender charge (In case of surrender before lock-in)

Additional surrender charges may be levied by policy providers as a penalty for their losses. So if you break the barrier of the lock-in period, then you may have to pay the surrender charge as a penalty.

3. Withdrawal charge (on withdrawal)

The company offering the tax-deferred savings plans might levy additional charges at the time of withdrawal of the fund, as withdrawal charges. These are generic charges and account towards the policy administration fee.

4. Tax Penalty

When a policyholder withdraws his/her policy before maturity, then an additional tax penalty is charged. These are charges as you have not paid the income tax on this amount, and you are choosing to violate the policy terms of the tax-deferred savings plan, under which the government allows a deferred income tax payment.

5. Annual fee

This is a mandatory fee that a policyholder needs to pay to the company as a fund maintenance fee. The policyholders are generally charged as much as 1% of the asset as a rider and management fee.

Benefits of Investing in a Tax-Deferred Savings Plan in India

In India, these plans are called deferred annuity plans. This is because of the fact that a series of payments is called an annuity, and you can withdraw as much as you want and whenever you want when invested in a deferred annuity plan.

The following are the benefits of investing in a deferred annuity plan:

1. Multiple payout options

Most savings plans offer only a limited payout option. However, a tax-deferred savings plan offers multiple payout options. This helps you in the easy and hassle-free withdrawal of funds.

2. Payment post-completion of the deferred period (generally 59.5 Years)

When you start investing in a tax-deferred savings plan, you understand it is a long-term savings plan. The best part is that the money accumulated in this plan may serve as a corpus to use in old age.

3. Benefits on tax (Tax savings)

When a person opts for a tax-deferred savings plan, then his/her tax payment is shifted to tax payment post 59.5 years. This helps you in saving your tax as you will be receiving a pension post-retirement, and it will most probably be in a lower income tax slab.

4. Ease of adding and withdrawing funds

A policyholder is free to add or withdraw funds at any time when opting for tax-deferred savings plans. This helps you understand more about your savings, manage your funds without hassle, and gives you the freedom to save more.

Tax-deferred 401(k)and IRA plans

Tax-deferred savings plans come in two major varieties: the 401(k) and conventional IRA. Investor savings are not taxed as income until they are withdrawn, often after retirement. The investor receives an immediate tax reduction because the amount saved is subtracted from gross income.

Other tax-deferred savings options

Life insurance

A person’s and his family’s financial goals can be met in a number of different ways with the aid of insurance. Tax advantages are available for all forms of life insurance plans, including endowment, term, and money back.

Public Provident Fund (PPF)

PPF is government-sponsored savings and direct tax-free investing programme for retirement planning. It is advantageous for people without a formal pension plan.

The debt market influences the PPF’s interest rate. Although partial withdrawals are allowed, the earliest one is after the sixth year, money is locked up for a 15-year period. Investors are not required to pay taxes on redemption proceeds.

New Pension Scheme (NPS)

The New Pension Scheme (NPS), overseen by the Pension Funds Regulatory and Development Authority or PFRDA, is a programme created to help people save for retirement.

It is open to all Indian citizens between the ages of 18 and 60. Due to the minimal fund management fees, it is cost-effective. Three separate accounts are used to manage money, each with a different asset profile, such as equity (E), corporate bonds (C), and government securities (G). Investors have the option of actively managing their portfolios or passively (auto choice).

The total amount that may be deducted under all of Section 80C’s subsections, including 80CCD and 80CCC, is limited to ₹1.5 lakhs.

Pension

Pensions are a type of life insurance that meets a distinct demand. Pension plans aim to support the individual and his family if he lives on, unlike protection plans (like term plans) which are designed to safeguard the individual’s family upon death financially.

Deposits

Both post office time deposits and 5-year bank fixed deposits generate tax-free income. For those who have limited tolerance for risk and want to accumulate savings over the long term, they are among the greatest tax-free investments available in India.

Conclusion

Now that you know much about the deferred savings plan, you can make an informed decision when choosing a tax-deferred plan. Moreover, now that you know about the functioning and benefits of tax-deferred savings plans, you can decide whether it fits your long-term financial goals or not. Investing without being informed can lead to loss through penalties and charges.

Experts believe that tax-deferred savings plans investment is a safe option for long-term investment if they fit your long-term investment criteria and financial priorities. Also, these plans are adequately regulated by strict financial laws.

FAQs

1. What is the difference between a 401k and a deferred compensation plan?

Plans for deferred compensation are financed informally. In essence, the company promises to pay the employee the postponed payments and any investment gains at the appointed period. In contrast, a 401(k) account has been formally formed.

2. What is an advantage of tax-deferred retirement savings?

An investment account known as a tax-deferred savings plan enables a taxpayer to avoid paying taxes on the money invested until it is withdrawn, typically after retirement. The most well-known of these programmes are 401(k)s and individual retirement accounts (IRAs).

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