When you're thinking ahead to retirement, tax planning should be part of your decision-making from the beginning. The two common retirement accounts that allow people to minimize their tax bills are tax-deferred and tax-exempt accounts.
To be clear, both types of retirement accounts minimize the amount of lifetime tax expenses an individual will incur. This provides an incentive to start saving for retirement at an early age. However, the most distinct difference between the two types of accounts is just when the tax advantages kick in.
Here's a look at these two types of accounts and the key difference that will help you decide which account—or combination of accounts—makes sense for you.
- Tax-deferred account contributions lower taxable income, meaning you'll pay taxes at a later time.
- Tax-exempt account withdrawals are tax-free, meaning you'll pay taxes up front.
- Common tax-deferred retirement accounts are traditional IRAs and 401(k)s.
- Popular tax-exempt retirement accounts are Roth IRAs and Roth 401(k)s.
- An ideal tax-optimization strategy may be to maximize contributions to both types of accounts.
How Tax-Deferred and Tax-Exempt Accounts Work
Tax-deferred accounts allow you to realize immediate tax deductions up to the full amount of your contribution. The money in your account grows undiminished by taxes. Future withdrawals from the account will be taxed at your ordinary income rate.
Tax-exempt accounts provide future tax benefits rather than tax breaks on contributions. Withdrawals at retirement are not subject to taxes. Since contributions to the account are made with after-tax dollars—meaning you fund it with money on which you've already paid taxes—there is no immediate tax advantage. The primary benefit of the tax-exempt structure is that investment returns grow and can be withdrawn entirely tax-free.
Investors can achieve major advantages by shifting the period when they pay taxes.
"I like to describe a tax-deferred account as really being tax-delayed," Mack Courter, CFP and founder of Courter Financial, LLC., in Manteo, North Carolina, said. "Taxes will be paid someday down the road. A tax-exempt account, however, is tax-free after the money is deposited into the account."
Types of Tax-Deferred Accounts
The most common tax-deferred retirement accounts in the United States are traditional IRAs and 401(k) plans. In Canada, the most common tax-deferred retirement account is a registered retirement savings plan (RRSP). Essentially, as this type of account's name implies, taxes on income are deferred to a later date.
For example, if your taxable income this year is $50,000 and you contribute $3,000 to a tax-deferred account, you would pay tax on only $47,000. In 30 years, once you retire, if your taxable income for a particular year is $40,000, and you decide to withdraw $4,000 from the account, your total taxable income would be bumped up to $44,000.
The IRS routinely adjusts 401(k) and IRA contribution limits for inflation. For 2023, you can contribute up to $22,500 to a 401(k) plan and make a $7,500 catch-up contribution if you're age 50 or older. The maximum contribution limit for traditional (and Roth IRAs) is $6,500, with an additional $1,000 in catch-up contributions if you are age 50 or older. In 2024, the 401(k) limit is $23,000. The maximum catch-up contribute for those 50 and older to their 401(k)s will remain $7,500. The IRA (and Roth) contribution limit for 2024 is $7,000. Those 50 and older can make an additional $1,000 of catch-up contributions.
Participation in a workplace plan and the amount you earn may reduce the deductibility of some of your traditional IRA contributions.
Types of Tax-Exempt Accounts
Two of the most commonly-used tax-exempt accounts in the U.S. are the Roth IRA and Roth 401(k). Contribution limits for Roth IRAs and Roth 401(k)s are the same as for traditional IRAs and 401(k)s. In Canada, the equivalent of these accounts is a tax-free savings account (TFSA).
Qualified withdrawals from a Roth IRA are tax-free, however, there's a limitation on who can contribute. Taxpayers whose modified adjusted gross income (MAGI) is too high may not be able to contribute to Roth IRAs.
For 2023, you can make a full contribution to a Roth IRA if any of the following are true:
- You file single or head of household and your MAGI is less than $138,000
- You're married and file separately, didn't live with your spouse during the year and your MAGI is less than $138,000
- You're married, file a joint return and have a MAGI of less than $218,000
- You're a qualifying widow(er) with a MAGI of less than $218,000
For 2024, you can make a full contribution to a Roth IRA if any of the following are true:
- You file single or head of household and your MAGI is less than $146,000
- You're married and file separately, didn't live with your spouse during the year and your MAGI is less than $146,000
- You're married, file a joint return and have a MAGI of less than $230,000
- You're a qualifying widow(er) with a MAGI of less than $230,000
Contribution limits begin to phase out once your modified AGI exceeds the allowed thresholds until they eventually reach zero. Qualified withdrawals would be tax-free, regardless of income. Owners of a tax-deferred account, meanwhile, would pay ordinary income tax on contributions and earnings when they took distributions from their accounts.
Higher-income earners may be able to make backdoor Roth IRA contributions by first contributing to a traditional IRA, then converting those amounts.
Benefits of Tax-Deferred vs. Tax-Exempt Accounts
The immediate advantage of paying less tax in the current year provides a strong incentive for many individuals to fund tax-deferred accounts. The general thinking is that the immediate tax benefit offered by current contributions outweighs the negative tax implications of future withdrawals.
When individuals retire, they may generate less taxable income and thus find themselves in a lower tax bracket. Typically, high earners are strongly encouraged to maximize their tax-deferred accounts to minimize their current tax burden.
Also, by receiving an immediate tax advantage, investors can put more money into their accounts.
For example, let's say that you pay a 24% tax rate on your income. If you contribute $2,000 to a tax-deferred account, you will receive a tax refund of $480 (0.24 x $2,000) and be able to invest more than the original $2,000, which will make it compound at a faster rate.
This assumes that you didn't owe any taxes at the end of the year. Though, if you did have some taxable income, the tax deduction due to contributions would reduce the taxes owed. All in all, increasing your savings can provide tax benefits and peace of mind.
Some people ignore tax-exempt accounts because their tax benefits can occur as far as 40 years into the future. However, young adults who are either in school or are just starting work are ideal candidates for tax-exempt accounts like Roth IRAs. At these early stages in life, their taxable income and the corresponding tax bracket are usually minimal but will likely increase in the future.
By opening and contributing regularly to a tax-exempt account, individuals will be able to access their funds, along with the capital growth of their investments, without any tax concerns. Since withdrawals are tax-free, taking money out in retirement will not push investors into a higher tax bracket.
“The conventional belief that taxes will be lower in retirement is outdated,” Ali Hashemian, CEO of Kinetic Investment Management in Los Angeles, California, said. “The modern retiree spends more money and generates more income than previous generations did. Also, the tax environment may be worse for retirees in the future than it is today. These are just some of the reasons that tax-exempt strategies may be advantageous.”
“I cannot think of anyone who does not benefit from tax-exempt,” Wes Shannon, founder of SJK Financial Planning, LLC, in Hurst, Texas, said. “Oftentimes, a client who is in a high tax bracket and has a long-term growth-oriented investment strategy will be able to take advantage of capital gains and qualified dividend taxation—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 an ideal strategy may include maximizing contributions to both tax-deferred and tax-exempt accounts, it's not always possible to fully fund multiple retirement accounts. What you decide to do now can depend on where you are tax-wise—and where you expect to be later.
If You're in a Lower Tax Bracket Now
If you're in a lower tax bracket now, but expect to be in a higher tax bracket later, then funding a tax-exempt account like a Roth IRA could make sense. You won't get the benefit of a tax deduction upfront, but that may be less important if you're already paying taxes at a lower rate.
However, you could reap significant tax benefits later if your income climbs and pushes you into a higher tax bracket. If your expected future tax liability is likely to be higher than it is now, a tax-exempt account wouldn't add to your tax burden.
Even if your tax bracket doesn't rise, you can still get an advantage from having a source of tax-free income to tap into when you retire. And if you don't need to withdraw money to fund retirement expenses right away, you could leave it to continue growing since Roth IRAs don't have required minimum distributions.
If You're in a Higher Tax Bracket Now
If you're currently in a higher tax bracket, then you may prefer funding a traditional IRA or a 401(k) in place of a tax-exempt account. The immediate benefit is that making deductible contributions can lower your marginal tax bracket, resulting in tax savings. Depending on your income level, you might be phased out of contributing to a Roth IRA anyway.
When it's time to retire, you'll have to pay income tax on qualified withdrawals from a traditional IRA or 401(k). How much of a tax blow that deals to you can depend on your income at retirement and which tax bracket you fall into. Finding ways to maximize your deductions can help to lessen some of the impacts of taking qualified withdrawals from a tax-deferred plan.
For instance, you could make qualified charitable distributions (QCDs) to an eligible charity to offset the required minimum distributions from a traditional IRA. As long as the money goes directly to an eligible organization from your IRA, you can avoid having to claim the distribution as taxable income, though you will still need to report it on your tax return.
If you're planning to make QCDs from an IRA to get a tax break, it's best to request a direct transfer through your IRA custodian to avoid unwanted tax consequences.
Aside from your tax situation, another crucial variable to consider is the purpose and time frame for your savings. Tax-deferred accounts are usually, but not always, preferred as retirement vehicles since many people will have minimal earnings and may have a lower tax rate during this after-work life stage. Tax-exempt accounts are often preferred for investment purposes since an investor can realize significant tax-free capital gains.
"I actually think clients often load up too much on tax-deferred accounts," Marguerita Cheng, CEO of Blue Ocean Global Wealth in Gaithersburg, Maryland, said. "Just as we preach investment diversification, tax diversification is just as important. It's important to realize tax savings today. However, there is 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 is a powerful trifecta."
Whatever your financial needs, a financial advisor can help you decide which type of account is best for you.
Frequently Asked Questions (FAQs)
What's the Difference Between Tax-Deferred and Tax-Exempt Accounts?
With a tax-deferred account, you get an up-front tax deduction for contributions you make, your money grows untouched by taxes, and you pay taxes later on your withdrawals. With a tax-exempt account, you use money that you've already paid taxes on to make contributions, your money grows untouched by taxes, and your withdrawals are tax free.
Can I Have a Tax-Deferred IRA If I Have a Retirement Plan at Work?
Yes, you may. However, what you can deduct from taxable income will vary. Generally speaking, your deduction will begin to decrease (or, as the IRS puts it, phase out) when your income rises above a certain level. It will be eliminated completely if your income then reaches a higher amount. These deductible amounts also will vary based on your filing status. IRS Publication 590-A can provide you with the details.
If I Max Out My Traditional Tax-Deferred IRA, Can I Still Contribute to a Roth?
No. You can only contribute to both when you break up the total annual amount allowed by the IRS between them. For example, if you're age 50 in 2023 and you contributed the maximum allowed annual amount of $7,500 to your tax-deferred IRA or $8,000 in 2024, you wouldn't be allowed to contribute anything to your Roth for the same year. If you're under 50 the maximum contribution is $1,000 less. Keep in mind, the amount you can contribute to a Roth is limited and even eliminated once your annual income hits certain levels.
The Bottom Line
Tax planning is an essential part of any personal budgeting or investment management decision. Tax-deferred and tax-exempt accounts are among the most commonly available options to facilitate financial freedom during retirement.
When considering the two alternatives, just remember that you are always going to pay taxes. Depending on the type of account, it's simply a question of when.