Tax planning is an essential part of any personal budgeting or investment management decision. Two basic types of accounts which allow people to minimize their tax bills are generally offered: tax-deferred accounts (TDA) and tax-exempt accounts (TEA). Both accounts minimize the amount of lifetime tax expenses one will incur, thus providing incentives to start saving for retirement at an early age.
TUTORIAL: Registered Retirement Savings Plans
Distinction Between the Accounts
Tax-deferred accounts allow for immediate tax deductions to be realized on the full amount of the contribution. However, future withdrawals from the account will be taxed. For example, if your taxable income this year is $50,000 and you contributed $3,000 to a TDA, you would pay tax on only $47,000. In 30 years, once you retire, if your taxable income is initially $40,000 but you decide to withdraw $4,000 from a TDA account, taxable income would be bumped up to $44,000. Essentially, as the name of the account implies, taxes on income are "deferred" to a later date. In Canada, the most common type of TDA is an RRSP, and in the U.S. it is the Traditional IRA. (It may be better to leave your assets exposed to the tax man when you're saving to retire. Check out Not All Retirement Accounts Should Be Tax-Deferred.)
Tax-exempt accounts, on the other hand, provide future tax benefits as withdrawals at retirement are not subject to taxes. Since contributions into the account are made with after-tax dollars, there is no immediate tax advantage. The primary advantage of this type of structure is that investment returns realized within the TEA grow tax-free. If you contributed $1,000 into a TEA today and the funds were invested into a mutual fund which provided a yearly 3% return, in 30 years the account would be valued at $2,427 (1,000*1.03^30). In contrast, in a regular taxable investment portfolio where one would pay capital gains taxes on $1,427, if this investment was made through a TEA, growth is not taxed. In Canada, the most common type of TEA is a tax-free savings account (TFSA), and in the Untied States, the Roth IRA is a popular TEA.
With a TDA, taxes are paid in the future. With a TEA, taxes are paid right now. However, by shifting the period when you pay taxes and realizing tax-free investment growth, major advantages can be realized.
Account Benefits - Tax-Deferred
The immediate advantage of paying less tax in the current year provides a strong incentive for many individuals to fund their tax-deferred accounts. General thinking is such that the current tax benefit of current contributions outweighs the negative tax implications of future withdrawals. When individuals retire, they will likely generate less taxable income and therefore find themselves in a lower tax bracket. High earners are strongly encouraged to max out their TDA accounts to minimize their current tax burden.
Also, by receiving an immediate tax advantage, an investor can actually put more money into their account. For example, assume that you are paying a 33% tax rate on your income. If you contribute $2,000 to a tax-deferred account you will receive a tax refund of $660 (0.33 x $2,000) and thus be able to invest more than the original $2,000 and have it compound at a faster rate. This is assuming you didn't owe any taxes at the end of the year, in which case the tax savings would simply reduce your taxes owed. (Increasing your savings will provide tax benefits - and peace of mind. See Maxing Out Your RRSP.)
Account Benefits - Tax-Exempt
Because the benefits of TEAs are realized as far as 40 years into the future, some people will often ignore these accounts. However, young adults who are either in school or are just starting work are ideal candidates for tax-exempt accounts. At these early stages in life, one's taxable income and the corresponding tax bracket are usually minimal but will likely increase in the future. Although the TFSA allows missed contributions to roll over, meaning that if you did not contribute the maximum amount this year you will be able to add that amount to next year's allowed contribution, in future years you are likely to generate more income and find yourself in a higher tax rate.
By opening a TEA today and investing this money into the market, the individual will be able to access these funds along with the additional capital growth without any tax concerns. Since withdrawals from this type of account are tax-free, taking money out in retirements will not push you up into a higher tax bracket.
Which Account is Right for You?
While the ideal tax optimization strategy would involve maximizing contributions to both tax-deferred and tax-accounts, there are certain variables to consider if such allocation is not possible.
Low-income earners are encouraged to focus on funding a TEA. Firstly, at this stage, contributions to a TDA would not make much sense seeing as how the current tax benefit would be minimal but the future obligation would be large. Someone who contributes $1,000 into a tax-deferred account when they incur a 15% income tax would only save $150 today. If those funds are withdrawn in five years when the person is in a higher tax bracket and pays a 30% income tax, $300 will be paid out. On the other hand, contributions into a TEA are taxed today, but, assuming that you will be exposed to a higher tax bracket in proceeding years, your future tax bill will be minimized.
Higher salary earners should focus on contributions to a tax-deferred account such as an RRSP or Traditional IRA. The immediate benefit can lower your marginal tax bracket, resulting in significant value. Your current and expected future tax brackets are the primary driving factors in determining which account is most suitable for your tax-planning needs.
Another crucial variable to consider is the purpose and time-frame for your savings. TDAs are usually, but not always, preferred as retirement vehicles since most people will have minimal earnings and low tax rates at this life stage. TEAs are often preferred for investment purposes, since an investor can realize significant tax-free capital gains.
Whatever you your financial needs, a financial advisor would be able to suggest which type of account is best for you. (Consolidating retirement assets? Make sure you account for pre-tax and after-tax assets separately. Read How After-Tax Rollovers Affect Your IRA.)
The Bottom Line
Tax-deferred and tax-exempt accounts are among the most common available alternatives to facilitate financial freedom during retirement. When considering the two alternatives, just remember that you are always paying tax - depending on your type of account, it's only a question of when.