An Expat Guide to Tax-Deferred Growth and Its Benefits

In this guide, we will explain the definition of tax-deferred growth, explore its benefits, and introduce accounts and investment products that provide tax deferral.

What Is Tax-Deferred Growth?

Tax-deferred growth refers to the accumulation of investment earnings, such as interest, dividends, or capital gains, that are not subject to tax until an individual withdraws the funds. Your withdrawals are taxed as regular income and are subject to your marginal tax rate.

How Does Tax Deferral Work?

Tax deferral delays taxation of asset growth until the funds are withdrawn, which means the accrued returns are compounded. The age at which you are permitted to withdraw funds without incurring penalties depends on the investment vehicle and your country of residence.

Typically, you’re eligible for a penalty-free withdrawal in retirement. Since employment income usually ceases at this stage, many retirees fall into a lower tax bracket, allowing them to access their accumulated, tax-deferred funds at a potentially lower tax band.

What Is the Difference Between Tax-Free Growth vs Tax-Deferred Growth vs Taxed Growth?

The table below illustrates the primary differences between tax-free growth vs tax-deferred growth vs taxed growth:

Tax-free accounts shouldn’t be mistaken for tax-exempt accounts. The latter enables you to make tax-free withdrawals, but only because the contributions are made with post-tax dollars, meaning taxes are deducted before the contributions are paid into your account.

An example of such accounts is Roth IRAs in the US or individual savings accounts (ISAs) in the UK.

How Does Tax-Deferred Growth Impact Your Savings?

The benefits of tax-deferred growth become most apparent when compared to taxable accounts.

To estimate how long it will take for your investment to double under each scenario, the following formulas offer useful approximations:

1. The Rule of 72: For tax-deferred accounts – divide 72 by your annual return to estimate doubling time.
2. The Rule of 96: For taxable accounts – use 96 due to annual tax drag. (These are approximations and assume consistent growth and reinvestment.)

Supposing a federal return rate applies to taxable accounts on top of their annual interest rate, the following table outlines the number of years it will take to double the investment in each account:

Example:

To illustrate the difference in how much growth you can achieve in a taxed vs tax-deferred account, we will use the following hypothetical example:

Over 15 years, the tax-deferred account benefits from uninterrupted compounding and will accumulate significantly more funds than the taxed one, due to the annual taxation slowing down investment growth.

What Accounts Have Tax-Deferred Growth?

Various accounts, including investment, retirement, and savings accounts, provide tax-deferred growth. We will explore the following in more detail:

1. Retirement accounts
2. Offshore investment bonds
3. Savings bonds
4. Deferred annuities

Retirement Accounts

In most jurisdictions, local and international individual retirement accounts provide tax-deferred growth of the invested funds, reducing your annual tax liability. Expats often utilise the following retirement accounts to mitigate annual taxes until retirement:

Additionally, workplace pensions established by your employer typically include tax-deferred growth. These are, for instance, 401(k)s in the US or defined benefit and defined contribution schemes in the UK.

Offshore Investment Bonds

Offshore investment bonds are tax wrappers that provide access to a wide selection of investments, but require retention of the capital within the bond for 5–10 years. They’re typically established by insurance companies in jurisdictions with favourable tax laws, such as:

• The Isle of Man
• Luxembourg
• Guernsey

Bonds are available to individuals worldwide and are particularly beneficial to expats, as they provide access to international investments and allow investments in multiple currencies.

Offshore bonds are well-known for their tax advantages. Their gross roll-up feature enables tax-deferred investment growth, meaning tax liability only arises upon withdrawal or bond surrender. Therefore, taxation can be delayed until a later stage—typically when the policyholder transitions into a lower tax bracket.

Under current UK tax rules, offshore investment bonds allow policyholders to withdraw up to 5% of the original investment amount each policy year without immediate tax liability. This is treated as a return of capital, not income.

Any unused allowance can be carried forward cumulatively. Tax becomes payable when total withdrawals exceed the original investment or on full surrender.

However, when you surrender the bond, you’ll be liable for tax on investment growth and the initial capital, including the tax-deferred withdrawals.

If you have invested in an offshore bond but aren’t satisfied with the returns, financial advisers at Titan Wealth International provide a complimentary review of your current offshore bond. They assess its performance against your financial goals and tailor it to your needs to ensure tax-efficient investment growth.

Savings Bonds

Savings bonds are debt instruments issued by the government or private companies to collect funds from the public and use them to finance capital projects and similar operations. Investing in a bond means lending money to the issuer, who agrees to repay the invested amount with interest.

Bond distributions are typically paid twice a year, while you receive the principal amount when the bond matures, which can be 1–30 years, depending on the agreed-upon terms.

Savings bonds typically provide tax-deferred growth of your investment. For instance, the interest earned on EE Bonds in the US is subject to a deferral from state, local, and federal taxes until the bond matures or is cashed in.

Deferred Annuities

Deferred annuities are contracts with insurance companies that promise to provide regular income or pay lump sum benefits in the future.

During the accumulation phase, you make contributions to a deferred annuity, either as a lump sum or periodic payments. Your funds will grow tax-deferred until the payout phase—the day you start to receive income from the annuity.

The funds in these accounts are taxable upon withdrawal at your marginal tax rate. However, they can also function as tax-exempt accounts if your provider allows post-tax contributions.

There are three types of annuities:

1. Fixed annuities: The returns on these annuities are lower compared to the other types, but they have a guaranteed minimum return on the funds in the account.
2. Variable annuities: These annuities invest your fund in sub-accounts that provide access to investments like stocks and bonds. They don’t have a guaranteed minimum return, but the interest rate can be higher, depending on the investments’ performance.
3. Indexed annuities: The performance of these annuities is linked to a market index, like the S&P 500, meaning your returns depend on the index’s performance. They have a guaranteed minimum rate and a maximum rate of return.

What Are the Benefits of Tax-Deferred Growth?

The primary benefit of tax-deferred growth is the ability to postpone your tax liability until retirement, minimising taxation and maximising investment growth. More specifically, tax deferral provides the following advantages:

1. Lower annual tax bill
2. Compounding potential
3. Tax reduction in the long term

Lower Annual Tax Bill

Since tax deferral postpones your tax liability until a later date, it reduces your taxable income in the current year, potentially placing you in a lower tax bracket.

For instance, if your annual income in the UK (including investment gains within the account) is £60,000 without a tax deferral, you’d be liable for tax at a higher 40% rate.

Meanwhile, if you hold £10,000 worth of investment gains in a tax-deferred account, your annual taxable income would reduce to £50,000 (more precisely, £37,430 after the tax-free allowance), subjecting you to the basic tax rate of 20%.

Additionally, some tax-deferred accounts, such as offshore bonds and retirement plans, aren’t liable to capital gains tax, allowing you to buy and sell assets without triggering CGT as long as the funds stay within the account.

Compounding Potential

Tax deferral significantly enhances the compounding effect—a mechanism that involves reinvesting the account’s earnings to accelerate the accumulation of funds. Without annual taxation, more funds remain available for reinvesting, leading to faster and more efficient wealth accrual.

Tax Reduction in the Long Term

Tax-deferred accounts facilitate long-term tax efficiency. They are beneficial for individuals who anticipate being in a lower tax bracket in retirement, when the accumulated funds will be taxed at rates lower than those the individual was exposed to before retirement.

What Are the Drawbacks of Tax-Deferred Growth?

While tax-deferred growth is generally beneficial for investment growth, accounts with such tax advantages may include several drawbacks, including the following:

• Contribution limits: Tax-deferred accounts sometimes include maximum contribution limits. For instance, individual savings accounts in the UK have an annual contribution threshold of £20,000 per tax year, limiting growth accumulation.
• Early withdrawal penalties: Many tax-deferred accounts include early withdrawal penalties, potentially reducing your savings. For instance, offshore bonds include fees of up to 9.5% if you withdraw funds from the bond within a specific period after investing. Meanwhile, withdrawing funds from 401(k)s or IRAs before age 59½ results in a 10% penalty, as well as income tax owed on the withdrawn amount.
• Mandatory withdrawals: Some tax-deferred accounts, like traditional IRAs and 401(k)s in the US, require specific minimum distributions once you turn 73. Therefore, although the funds grow tax-deferred, you must eventually pay tax on them.

Consulting a financial adviser can help you create an investment strategy tailored to your specific financial circumstances, ensuring you avoid penalties, minimise taxes, and enhance wealth growth over time.

How Is Tax-Deferred Growth Different for Expats?

Holding a tax-deferred account in one country while living in another requires careful navigation of cross-border taxation and reporting rules. More specifically, expats should include the following in their planning:

1. Cross-border tax treatment
2. Future tax bracket considerations

Cross-Border Tax Treatment

A tax-deferred account held in one jurisdiction may not enjoy the same tax treatment in another. Therefore, if you hold a tax-deferred account in one country but reside in another, it’s essential to understand how your residency may impact your tax liability.

For instance, if you’re an Australian tax resident holding retirement savings in a US-based tax-deferred account like a traditional IRA, the taxation of the invested fund will be postponed until withdrawal in the US. However, the Australian Taxation Office (ATO) treats US IRAs and 401(k)s as foreign trusts.

Pre-tax contributions (corpus) are not taxable, but earnings are taxed as assessable income under Section 99B of the Income Tax Assessment Act. This can result in double taxation unless a treaty exemption applies (ATO guidance). According to the tax laws of each country, your IRA funds could be subject to double taxation since Australia imposes income tax on earnings, while the US levies the 30% withholding tax on withdrawals from traditional IRAs made by US non-residents.

Due to the potential tax issues, it’s necessary to consult a financial adviser for expert cross-border tax advice to minimise tax liabilities.

Future Tax Bracket Considerations

Since withdrawals from tax-deferred accounts are taxed as income, the jurisdiction in which you are considered a tax resident during retirement can significantly impact your net returns.

Anticipating future tax brackets and residency status is essential to preserving the value of your retirement savings.

For instance, if you hold a tax-deferred account in the US, where the federal income tax rate is up to 37% and decide to retire in a higher-tax jurisdiction like Finland, withdrawals from the US-based tax-deferred account will be subject to a progressive tax rate of up to 55% in Finland once you become a Finnish resident.

Conversely, relocating to a jurisdiction that doesn’t impose income taxes, such as the UAE, would allow you to withdraw the funds from a tax-deferred account, such as a SIPP, without incurring any tax liability.

Although SIPPs are subject to UK taxation, individuals who become tax residents in the UAE may benefit from the UK-UAE double taxation agreement, which stipulates that pension income should be taxable only in the country of residence.

As the UAE does not levy personal income tax, this effectively renders SIPP withdrawals tax-free.

When To Consider Tax Deferral as an Expat?

Expats, especially international investors, can benefit from a tax-deferred account if they belong to one of the following categories:

• Long-term investors: Tax-deferred accounts are most advantageous for long-term investors, as prolonged investment periods enable greater compounding potential while avoiding early withdrawal penalties.
• Expats retiring in a lower-tax jurisdiction: Those planning to retire in a lower or no-tax jurisdiction can utilise tax-deferred accounts to grow their assets without immediate taxation and withdraw them during retirement at more favourable tax rates.
• Expats planning to repatriate: Expats who currently reside in a higher tax jurisdiction but plan to return to a lower tax country in the future can leverage tax deferral to delay their tax obligations until they return home.
• Higher-rate taxpayers: Investors and expats in a higher tax bracket who expect a descent into lower tax bands once they stop receiving employment income may consider tax-deferred accounts, as they won’t be subject to immediate tax on contributions and gains.