Understanding the difference between tax-deferred and tax-free is key to planning for retirement. Most retirement accounts fall into these two categories so it’s critical to know which ones are which.
Tax-Deferred Retirement Accounts
Simply put, this method of taxation means you’ll pay the taxes later. In an effort to encourage individuals to save for their retirement, the government provides this tax incentive. Funds you contribute to a retirement account won’t be taxed until you withdraw the funds. The most common type of retirement accounts with this feature are IRAs, SIMPLE IRAs, 401(k)s, and 403(b)s to name a few. (For related reading from this author, see: Individual 401(k) vs SEP IRA: Deductions and Contributions.)
There are two main concepts that make this attractive. First, shielding funds from capital gains and dividend taxes will allow more of the funds to remain invested and increase the effects of compounding returns. The greater the number of years until retirement, the greater the benefit of the tax deferral. This is yet another reason to start saving early. Second, when you withdraw funds during retirement, the idea is that you’ll owe less in taxes on the distribution. This assumes you’re in a lower tax bracket during retirement than you were when you originally made the contribution to the retirement account.
Tax-deferred is not to be confused with tax-deductible. For example, one could make a contribution to an IRA and not be allowed the tax deduction. However, you would still receive the tax-deferred status on the investment’s earnings from capital gains and dividends. It should be noted however, that taking a deduction from income or reducing your salary through a 401(k) or 403(b) will give you the biggest bang for your buck.
Tax-Free Retirement Accounts
Probably the least understood and most under-utilized form of taxation for retirement accounts is the tax-free method. This form of taxation allows one to make contributions to a retirement account and receive the same benefits of tax-deferred accounts while the money is invested. Most notably, these accounts are Roth IRAs and 401(k) and 403(b) plans with Roth features (tax-free). However, there is one huge difference. With a tax-free account, you pay no taxes when the funds are taken out during retirement. This is in contrast to a tax-deferred account where you pay income tax on whatever you spend from the account. (For related reading, see: The Basics of Roth IRA Contribution Rules.)
The key point to understand about tax-free accounts is that they don’t offer an immediate tax benefit like deductible IRA contributions and salary contributions to a 401(k), 403(b), or SIMPLE IRA plan. With these tax-deferred plans, you are reducing your income tax liability for the year in which the contributions are made, thus reducing your tax bill. With tax-free accounts like Roth IRAs and company retirement plans with Roth features, contributions are made “after tax,” so you don’t get an immediate income tax savings.
To make matters a little more complicated, company retirement plans with Roth features (tax-free) will have a combination of tax-deferred and tax-free elements. This occurs because a 401(k) that pays matching and/or profit-sharing contributions is doing so under the tax-deferred method while your salary contributions are after-tax and will be considered the tax-free portion.
Tax-deferred and tax-free are both important components of a strong financial foundation. Understanding these concepts will result in better decisions about your retirement now and into the future.
(For more from this author, see: What You Should Know About IRA Beneficiaries: Part 1.)