Tax-Deferred vs. Tax-Exempt Retirement Accounts: What’s the Difference?

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Tax-Deferred vs. Tax-Exempt Retirement Accounts: What’s the Difference?

Tax-Deferred vs. Tax-Exempt Retirement Accounts: An Overview

When preparing for retirement, tax preparation should be part of your decision-making process from the start. Tax-deferred and tax-exempt accounts are the two most frequent types of retirement accounts that enable customers to reduce their tax costs.

To be clear, both forms of retirement accounts reduce a person’s lifetime tax liabilities. This creates an incentive to begin saving for retirement at a young age. The main difference between the two kinds of accounts is when the tax benefits kick in.

Here’s an overview of these two kinds of accounts, as well as the important differences that will help you determine which account—or combination of accounts—is best for you.

Key Takeaways

  • Contributions to tax-deferred accounts reduce taxable income; you will pay taxes later.
  • Withdrawals from tax-exempt accounts are tax-free; you pay taxes beforehand.
  • Traditional IRAs and 401(k)s are two types of tax-deferred retirement funds.
  • Roth IRAs and Roth 401(k)s are popular tax-free retirement funds.
  • Maximizing contributions to both kinds of accounts may be an optimal tax-saving approach.

How Tax-Deferred and Tax-Exempt Accounts Work

Tax-deferred accounts provide you with instant tax benefits up to the full amount of your investment. The money in your account will then grow unaffected by taxes. Withdrawals from the account in the future will be taxed at your regular income tax rate.

Rather than tax deductions on donations, tax-exempt accounts give future tax advantages. Withdrawals during retirement are not taxed. There is no immediate tax benefit since contributions to the account are made using after-tax funds (money on which you have previously paid taxes). The fundamental advantage of the tax-exempt structure is that investment returns grow tax-free and may be withdrawn tax-free.

Investors might gain significant benefits by altering the time when they pay taxes.

“I prefer to think of a tax-deferred account as a tax-delayed account,” says Mack Courter, CFP®, founder of Courter Financial, LLC. in Bellefonte, Pa. “Taxes will be paid at some point in the future. A tax-exempt account, on the other hand, is tax-free once the money is placed into it.”

Tax-Deferred Accounts

Traditional IRAs and 401(k) plans are the most prevalent tax-deferred retirement funds in the United States. The most prevalent in Canada is a registered retirement savings plan (RRSP).Essentially, as the term indicates, income taxes are delayed until a later period.

For example, if your taxable income is $50,000 this year and you deposit $3,000 to a tax-deferred account, you will only pay tax on $47,000. If your taxable income for a specific year is $40,000 and you elect to remove $4,000 from the account after 30 years, your total taxable income will be $44,000.

You may contribute up to $19,500 to a 401(k) plan in 2021, plus a $6,500 catch-up contribution if you’re 50 or older. You may donate up to $20,500 in 2022. The catch-up payment is still $6,500.

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You may contribute a maximum of $6,000 to a regular IRA in 2021 and 2022 (those 50 and over can add an extra $1,000).

Participation in a workplace plan, as well as the amount earned, may affect the deductibility of certain conventional IRA contributions.

The major deciding variables in selecting which account is most suited for your tax-planning requirements are your current and anticipated future tax brackets.

Tax-Exempt Accounts

The Roth IRA and Roth 401(k) are two popular tax-free accounts in the United States (k).The most prevalent in Canada is a tax-free savings account (TFSA).

Roth IRA and Roth 401(k) contribution limitations are the same as regular IRA and 401(k) contribution limits.

So, for 2021 and 2022, you may contribute up to $6,000 to a Roth IRA (those 50 and over can add an extra $1,000). People with too high a modified adjusted gross income (MAGI) may be unable to contribute to Roth IRAs.

You may contribute up to $19,500 to a 401(k) plan in 2021, plus a $6,500 catch-up contribution if you’re 50 or older. You may donate up to $20,500 in 2022. The catch-up payment is still $6,500.

If you donate $1,000 to a tax-exempt account today and the funds are invested in a mutual fund with a 3% annual return, the account will be worth $2,427 after 30 years. You will not pay taxes on any of the money you withdraw in retirement.

Capital Gains

In contrast, if the owner of a typical, taxable investment portfolio sold the shares, they would have to pay capital gains taxes on the $1,427 of increase. When taking distributions from a tax-deferred account, owners would pay regular income tax on their contributions and gains. It is worth noting that the long-term capital gains tax is less than the normal income tax.


Tax-Deferred Accounts

The immediate benefit of paying less tax in the current year is a major motivation for many people to contribute to tax-deferred accounts. The common consensus is that the immediate tax advantage provided by current contributions exceeds the unfavorable tax consequences of future withdrawals.

Individuals who retire may have less taxable income and consequently fall into a lower tax bracket. High incomes are often aggressively pushed to maximize their tax-deferred accounts in order to reduce their current tax burden.

Investors may also deposit more money into their accounts since they will get an instant tax benefit.

Assume you pay a 24% tax rate on your earnings. If you deposit $2,000 to a tax-deferred account, you will get a $480 tax return (0.24 x $2,000) and will be able to invest more than the initial $2,000, allowing it to compound quicker.

This implies you owed no taxes at the end of the year. However, if you did have taxable income, the tax deduction from contributions would lower the amount of taxes required. Overall, boosting your savings may give tax advantages as well as peace of mind.

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Tax-Exempt Accounts

Some individuals disregard tax-exempt accounts since the tax advantages might be realized up to 40 years in the future. Young individuals in school or just starting out in their careers, on the other hand, are great candidates for tax-exempt accounts. At this time of life, their taxable income and tax bracket are normally low, but they will most certainly grow in the future.

Individuals who create and contribute regularly to a tax-exempt account will be able to access their cash, as well as the capital growth of their assets, tax-free. Withdrawing money in retirement will not force investors into a higher tax rate since withdrawals are tax-free.

“The popular wisdom that taxes would be reduced in retirement is out of date,” says Ali Hashemian, MBA, CFP®, president of Kinetic Financial in Los Angeles. “Today’s retiree spends more money and earns more income than earlier generations.” Furthermore, the tax climate for retirees may be harsher in the future than it is now. These are only a few of the reasons why tax-exempt solutions may be beneficial.”

“I can’t think of anybody who doesn’t benefit from tax-exempt,” says Wes Shannon, CFP®, founder of Hurst, Texas-based SJK Financial Planning, LLC. “Often, a client in a high tax bracket with a long-term growth-oriented investment strategy will be able to take advantage of capital gains and qualified dividend taxation—both of which are currently at lower rates—whereas tax-deferred converts all gains into ordinary income, which is taxed at the higher rate.”

Which Account Is Right for You?

While the optimal tax optimization plan would entail maximum contributions to both tax-deferred and tax-free accounts, there are several factors to consider if such allocations are not available.

Low-Income Earners

Low-income people are advised to prioritize the creation of a tax-exempt account. Contributions to a tax-deferred account would make little sense at this point since the present tax advantage would be minor, but the future requirement may be substantial.

Someone who adds $1,000 to a tax-deferred account when their income tax is 12% saves just $120 now. If the funds are released after five years, when the individual is in a higher tax rate and pays a 32% income tax, $320 will be paid out.

Contributions to a tax-exempt account, on the other hand, are taxed today. So, if you end yourself in a higher tax rate later on, withdrawals from a tax-exempt account will be unaffected.

High-Income Earners

Contributions to a tax-deferred account, such as a 401(k) or conventional IRA, should be prioritized for higher-income employees. The immediate advantage might result in a large reduction in their marginal tax band.

Special Considerations

Another important factor to consider is the objective and timeline for your savings. Tax-deferred accounts are often favoured as retirement vehicles, but this is not always the case, since many individuals may have modest incomes and may have a reduced tax rate during this post-work life period. Because an investor may earn considerable tax-free capital gains, tax-exempt accounts are often favoured for investing reasons.

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“I honestly believe that customers often over-invest in tax-deferred accounts,” says Marguerita Cheng, CFP®, CEO of Blue Ocean Global Wealth in Gaithersburg, Maryland. “Tax diversification is just as essential as investment diversification. It is critical to gain tax savings now. There is something to be said, though, for tax-free or tax-exempt retirement savings. A potent trinity of dollar-cost averaging, time value of money, and tax-free development.”

Whatever your financial requirements are, a financial adviser can assist you in determining which sort of account is ideal for you.

What’s the Difference Between Tax-Deferred and Tax-Exempt Accounts?

With a tax-deferred account, you get an immediate tax deduction for contributions made, your money grows tax-free, and you pay taxes on withdrawals later. With a tax-exempt account, you make contributions with money you’ve already paid taxes on, your money grows tax-free, and your withdrawals are tax-free.

Can I Have a Tax-Deferred IRA If I Have a Retirement Plan at Work?

You certainly can. However, what you may deduct from your taxable income varies. In general, your deduction will begin to reduce (or, as the IRS calls it, phase out) when your income exceeds a specific threshold. If your income rises over a certain threshold, it will be entirely removed. These deductible amounts will also differ depending on your filing status. You may find further information in IRS Publication 590-A.

If I Max Out My Traditional Tax-Deferred IRA, Can I Still Contribute to a Roth?

No. You may only contribute to both if you divide the entire yearly amount permitted by the IRS. For example, if you’re 50 or older and contribute the maximum allowable yearly amount of $7,000 to your tax-deferred IRA, you won’t be able to contribute to your Roth that year. Keep in mind that the amount you may contribute to a Roth is restricted and, in certain cases, eliminated if your yearly income reaches certain thresholds.

The Bottom Line

Any personal budgeting or investment management choice must include tax preparation. Tax-deferred and tax-exempt accounts are two of the most prevalent ways to achieve financial independence in retirement.

When weighing the two options, keep in mind that you will always have to pay taxes. It’s only a matter of timing, depending on the sort of account.

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