Taking advantage of tax-deferred or tax-exempt accounts is one of the best ways to minimize your tax burden when you’re considering retirement.
Both types of retirement accounts are designed to minimize lifetime tax expenses. As a result, early retirement savings provide an incentive to save for retirement. However, the most notable difference between these two types of accounts is when the tax advantages start to kick in.
You can decide which type of account or combination of accounts is right for you by understanding the key differences between them.
- Contributions to tax-deferred accounts lower taxable income; taxes will be paid later.
- You pay taxes up front when withdrawing from a tax-exempt account.
- There are two types of tax-deferred retirement accounts: traditional IRAs and 401(k)s.
- IRAs and 401(k)s that are tax-exempt are popular among retirement accounts.
- Maximizing contributions to both types of accounts may be the best tax-saving strategy.
An overview of tax-deferred and tax-exempt accounts
Accounts with tax-deferred growth allow you to realize immediate tax deductions for the full amount of your contribution. It is then possible to withdraw money from your account at your ordinary income rate going forward.
In contrast to tax breaks on contributions, tax-exempt accounts offer future tax benefits. In addition, withdrawals at retirement are not subject to tax. Since the account is funded with after-tax dollars—meaning you’ve already paid taxes on that money—it doesn’t offer immediate tax benefits. The primary benefit of the tax-exempt structure is that investment returns grow and can be withdrawn entirely tax-free1.
Shifting the tax payment period can have major benefits for investors.
In Manteo, N.C., Mack Courter, CFP®, founder of Courter Financial, LLC., describes a tax-deferred account as really a tax-delayed account. While a tax-exempt account is tax-free once the money is deposited, a tax-deferred account is tax-deferred.
Accounts with a tax-deferred status
IRAs and 401(k) plans are the most popular tax-deferred retirement accounts in the United States. Registered retirement savings plans (RRSPs) are most common in Canada. They defer taxes on income until a later date, as their name suggests.
You would only pay tax on $47,000 if you contributed $3,000 to a tax-deferred account based on your $50,000 taxable income this year. Upon retiring in 30 years, if your taxable income for a given year is $40,000, and you withdraw $4,000, your total taxable income increases to $44,000 if you withdraw $4,000 from the account.
A 401(k) plan may allow you to contribute up to $20,500 in 2022, and $6,500 if you’re age 50 or older. In 2023, those amounts increase to $22,500 and $7,503.
Contributions to traditional IRAs are capped at $6,000 in 2022 (those over 50 can add an additional $1,000). In 2023, the contribution limit is $6,500, plus $1,000 catch-up contributions for people over 50.
You may also be able to deduct some of your traditional IRA contributions if you participate in a workplace plan and earn a certain amount.
When it comes to tax-planning, your current and future tax brackets are the primary determining factors.
Accounts Exempt From Taxation
The Roth IRA and Roth 401(k) are popular tax-exempt accounts in the United States. The most common tax-exempt account in Canada is the tax-free savings account (TFSA).
As with traditional IRAs and 401(k)s, Roth IRAs and Roth 401(k)s have the same contribution limits.
The maximum contribution you can make to a Roth IRA for 2022 is $6,000, and the maximum contribution for 2023 is $6,500. An additional $1,000 can be contributed to Roth IRAs if you are 50 or older. However, people whose modified adjusted gross income (MAGI) is too high may not be eligible.
Those limits will increase to $22,500 and $7,500 in 2023, respectively.3 In 2022, you can contribute $20,500 to a Roth 401(k) plan. if you’re 50 or older, you can add another $6,500.
The amount contributed to a tax-exempt account today would be valued at $2,427 in 30 years if invested in a 3%-yielding mutual fund. You will not be taxed on the withdrawals at retirement.
It is important to note that if an owner sold that $1,427 growth in a regular, taxable investment portfolio, they would have to pay capital gains taxes. If an owner of a tax-deferred account took distributions from their account, he or she would have to pay ordinary income tax on the contributions and earnings. Long-term capital gains tax is lower than regular income tax.
Differences between tax-deferred and tax-exempt accounts
Accounts that are tax-deferred
Most individuals are motivated to fund tax-deferred accounts by the immediate benefit of paying less tax now. According to general thinking, current contributions offer a greater tax benefit than future withdrawals, which has negative tax implications.
In retirement, individuals may earn less taxable income, resulting in a lower tax bracket. Generally, high earners should maximize their tax-deferred accounts to minimize their current tax bill.
Investors can also add more money to their accounts by receiving an immediate tax advantage.
Suppose your income is taxed at 24%; if you contribute $2,000 to a tax-deferred account, you will receive a tax refund of $480 (0.24 x $2,000) and can invest more than $2,000, which will allow your investments to compound more quickly.
All in all, increasing your savings can provide tax benefits and provide peace of mind if you didn’t owe any taxes at the end of the year. But if you did have some taxable income, the tax deduction for contributions would reduce your taxes owed.
Accounts exempt from taxes
Tax-exempt accounts are ignored by some people because their tax benefits can occur decades from now. However, tax-exempt accounts are ideal for young people just starting out in the workforce or in school. Their taxable income is usually minimal at these early stages in life, but it is likely to increase in the future.
In addition to having access to their funds and capital growth, individuals will not be taxed if they open and contribute regularly to a tax-exempt account. Taking money out in retirement will not push investors into a higher tax bracket since withdrawals are tax free.
Founder and CEO of Kinetic Investment Management in Los Angeles, Calif., Ali Hashemian, MBA, CFP®, says conventional beliefs about retirement taxes are outdated. A modern retiree spends more money and generates more income than the previous generation did. In addition, the future tax environment may be worse for retirees than it is now. These are just a few reasons why tax-exempt strategies may be advantageous.”
It is impossible for me to imagine anyone who does not benefit from tax-exempt investments, according to Wes Shannon, CFP®. When a client has a long-term growth-oriented investment strategy and is in a high tax bracket, they may be able to take advantage of capital gains and qualified dividend taxation – currently at lower rates. When tax-deferred gains are converted into ordinary income, they are taxed at the higher rate.
What is the best account for you?
Tax optimization strategies should aim to maximize contributions to both tax-deferred and tax-exempt accounts. However, if these allocations aren’t possible, a few variables need to be taken into account.
Earners with low incomes
A tax-deferred account has limited current tax benefits, but it might have a large future obligation, which is why low-income earners should focus on funding a tax-exempt account.
In five years, if the person contributes $1,000 to a tax-deferred account while facing 12% income tax, he or she will be able to withdraw those funds and save $320, since the tax rate has increased from 12% to 32%.
A tax-exempt account, on the other hand, is not taxed today. So, if you become in a higher tax bracket in the future, withdrawals won’t be affected.
Individuals with high incomes
Tax-deferred accounts, such as 401(ks) and traditional IRAs, can offer significant value to higher-salary earners. The benefits can be felt immediately by lowering your marginal tax bracket.
Considering your savings purpose and timeframe is another important factor. Many people will have minimal earnings during this after-work life stage and may have a lower tax rate, so tax-deferred accounts are often preferred as retirement vehicles, but not always. Since investors can realize significant tax-free capital gains from tax-exempt accounts, tax-exempt accounts are often preferred for investment purposes.
The CEO of Blue Ocean Global Wealth in Gaithersburg, Md., Marguerita Cheng, CFP®, says clients often overload their tax-deferred accounts. Tax diversification is as important as investment diversification. It is imperative to realize tax savings today. There is, however, something to be said for tax-free or tax-exempt retirement savings. “The combination of dollar-cost averaging, time value of money, and tax-free growth makes for an extremely powerful trifecta.”
You can consult a financial advisor to determine what type of account best suits your needs.
Why Are Tax-Exempt Accounts Different From Tax-Deferred Accounts?
Contributions to a tax-deferred account are deductible up front, while your money grows untouched by taxes, and withdrawals are taxed later. You can make contributions to a tax-exempt account using money you’ve already paid taxes on, and your money grows untouched by taxes and can be withdrawn tax-free.
Do I qualify for a tax-deferred IRA if I have a retirement plan at work?
If your income rises above a certain level, your deductions will begin to decrease (or, to put it another way, phase out). You can deduct taxable income in different ways. If you reach a higher income level, it will be completely eliminated. The amount of your deductible will also vary depending on your filing status. The IRS publication 590-A can provide you with more details.
Can I still contribute to a Roth IRA if I have maxed out my traditional tax-deferred IRA?
The IRS only allows you to contribute to both if you divide your total annual contribution amount between them. When you turn 50 in 2022, if you make a tax-deferred IRA contribution of $7,000, you won’t be able to make a Roth contribution. You’ll be able to contribute less to a Roth once your annual income reaches certain levels, and even no longer be able to do so.
In order to achieve financial freedom during retirement, tax-deferred and tax-exempt accounts can be a helpful tool.
Regardless of which account you choose, you will always be required to pay taxes. The only question is when.