What does it mean if an investment is tax-deferred?

When an investment is described as tax-deferred, it means that the taxes on the income generated from that investment are postponed until a later date, usually when the money is withdrawn. This allows the investment to grow without being subject to immediate taxation, enabling the capital to compound over time without the burden of annual tax liabilities.

For example, many retirement accounts, like 401(k)s and IRAs, fall into this category. The contributions made to these accounts can be tax-deductible, and the interest, dividends, or capital gains that accumulate while the funds are invested do not incur taxes until the account holder withdraws the funds, typically during retirement when they may be in a lower tax bracket. This characteristic is a significant advantage for long-term growth potential as it maximizes the amount of capital that can work for the investor over time.

The other options do not accurately capture the essence of tax-deferral. Immediate taxation would contradict the purpose of tax deferral, while being exempt from all taxes does not align with tax-deferred investments since taxes are applicable upon withdrawal. Additionally, incurring capital gains taxes annually contrasts the idea of tax deferral, which entails delaying such taxes.