Some countries allow for deferral of tax payment by contributing to an account which can then be deducted to income when calculating tax payment. The idea is to reduce the declared income for the year so that tax payment will also decrease. This tax deferral is called Traditional 401K in the US or RRSP in Canada.
I explained from my previous note that tax brackets at a higher income has higher percentage so in order to defer delay payment for income at a higher bracket you can set up and put an equivalent amount to a tax deferral account. When your tax is calculated, the amount you put in this account is then deducted from your net income hence saving the amount that you are supposed to pay for that income bracket for that year.
This is called tax deferral since you are not really avoiding the tax payment forever. The moment you make a withdrawal from this account, the money becomes your income and will be taxed based on the brackets of your income for the year. The purpose of this account is for your retirement since the expectation is that you will have lower income by that time because you are no longer employed hence any withdrawal from this account will end up being in a lower tax bracket.
Also, if you start contributing to this account when you are employed and it’s purpose is for your retirement then it is considered long term and it makes sense for the money to be invested for it to earn and grow. So by the time you are retired, the hope is that the amount that you put in and invested over the years will have grown and it will take longer to deplete it.
Some employers also offer contribution matching to this account up to a certain level. This means that you can put money to this account and your employer will match a portion of it. I always advise to take advantage of this offer since it’s free money and if it’s sustained and invested over the years, then it can become significantly larger than your actual contribution.