Retirement Savings: Tax-Deferred or Tax-Exempt?
There are two major options for retirement savings: tax-deferred and tax-exempt.
Published July 7th, 2020
Updated December 15th, 2020
- There are two major options for retirement savings: tax-deferred and tax-exempt.
- A tax-deferred account lets you delay paying taxes until you retire. Examples include traditional 401(k)s and traditional IRAs.
- With a tax-exempt account, you pay taxes now and enjoy tax-exempt distributions when you retire. Examples include Roth IRAs and Roth 401(k)s.
It’s never too late to start saving for retirement. If your employer sets this up for you, you may have all the support you need. But initiating a retirement plan on your own is fairly simple. The hardest part is choosing the type of plan and how much to put in.
The two most popular types of retirement plans are IRAs and 401(k)s. But both of these have two major types: traditional and Roth. “Is a Roth IRA tax-deferred or tax-exempt?” may be your next question. Traditional 401(k)s and IRAs are what’s known as tax-deferred accounts, while Roth 401(k)s and IRAs are tax-exempt.
We have the details on the difference, as well as some tips to help you choose between the two.
Difference between tax-deferred and tax-exempt accounts
There’s no shortage of options when it comes to saving for retirement. You’ll see 401(k)s, Roth IRAs, traditional IRAs, and more. As you’re looking into each option, the tax-deferred definition and tax-exempt definition have one major differentiator: when taxes are taken out.
With a tax-deferred account, you’ll pay no taxes when the money goes in. The taxes are deferred, or delayed, until you take the money out when you retire. A tax-deferred retirement plan can save you money on taxes today, though. Traditional 401(k)s and traditional IRAs are examples of tax-deferred accounts. Often, you’ll get a tax-deferred retirement option as an employment benefit, with your employer depositing the funds directly from your paycheck before taxes have been taken out.
A tax-exempt account deposits the funds after taxes have been taken out. Your employer may have set it up that way or you may contribute the money into the account yourself. This means at retirement time, you won’t owe taxes on the money you take out of the account. A traditional IRA or 401(k) tax-deferred account comes with a tax bill upon retirement. Examples of tax-exempt accounts are Roth IRAs and Roth 401(k)s.
When you explore your retirement options, it’s important to first understand what does tax-deferred mean. To defer something is to delay it. With tax-deferred, you’re delaying paying taxes to when you withdraw, in a way that follows IRS regulations.
The main difference to understand between tax-deferred and tax-exempt accounts is when taxes are taken out.
The advantage of a tax-deferred account is that you don’t pay taxes today on the money you’re putting in, you will pay taxes on the money when you withdraw during retirement. Chances are, your income will be lower during retirement than when you are working, which will likely put you in a lower tax bracket. If that happens, you can save money by paying lower income taxes by deferring withdrawal until retirement. But keep in mind that you will be paying taxes on any earnings, such as interest or capital gains, on your tax-deferred retirement funds at the time of withdrawal as well.
If you want to enjoy a tax-free retirement payout once you stop working, a tax-exempt account may be a better option. You’ll pay income taxes now, which means that when it’s retirement time, the money comes out tax-free - you won’t have to worry about paying any taxes on the earnings on your retirement investments when you withdraw your funds. This can be a huge relief, especially if you’re looking at a reduced income in your golden years, and want to avoid worrying about taxes in the future.
Having reviewed the tax-deferred meaning, you may wonder what’s in it for you now with a tax-exempt account. That’s the tough part. You won’t get immediate benefits from a tax-exempt account like a Roth IRA or Roth 401(k). Instead, you’ll get tax-free distributions down the line, which may be helpful if you think you will be in a higher tax bracket when you retire than you are currently, or if you don’t want to worry about paying taxes on the earnings, such as capital gains or interest, on your retirement funds.
Choosing the right retirement account
If you’re looking into tax-deferred investments, the first step is determining where you fall in the tax brackets. If you’re in a lower tax bracket, a tax-exempt account makes more sense. You’re already in a low bracket, so deferring the taxes until later will likely just mean you pay the higher tax rates that will probably be in place years from now when you retire.
Higher-income taxpayers should take the opposite strategy, though. You’ll benefit from not paying taxes now, when you fall within a higher tax bracket, and enjoy a lower rate when you retire and switch from regular work income to relying on savings and investments.
With both traditional and Roth IRAs, there are income limits on who may contribute to these types of accounts. These income limits change year-to-year. However, employer-based plans like 401(k)s or Roth 401(k)s are another avenue for you to get tax diversification regardless of your income level.
Although lower-income earners may benefit from tax-exempt retirement savings and higher-income earners may benefit from deferring taxes, there are plenty who fall in between those two extremes. Depending on how or if you choose to invest your retirement account funds, you may also be concerned about the benefit of a tax exempt retirement account for avoiding taxes on the earnings on your retirement funds. Likewise, we cannot predict how tax laws will change in the future when it comes time for your retirement. That’s why it’s prudent to consider an overall strategy to minimize any potential tax risk in retirement. There are also considerations like other retirement accounts and the age you plan to retire. We recommend sitting down with an experienced Certified Financial Planner® to chart the right course for your own circumstances.