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.

Here's a look at these two types of accounts and the key difference that will help you decide which account—or if having a combination of both—makes sense for you.

Key Takeaways

  • With a tax-deferred account, tax savings are realized when you make contributions, but with a tax-exempt account, withdrawals are tax-free in retirement.
  • Common tax-deferred retirement accounts are traditional IRAs and 401(k)s.
  • Popular tax-exempt accounts are Roth IRAs and Roth 401(k)s.
  • An ideal tax-optimization strategy may be to maximize contributions to both types of accounts.

Tax-Deferred vs. Tax-Exempt Accounts

Just to be clear: Both types of retirement account minimize the amount of lifetime tax expenses someone will incur, which provides incentives to start saving for retirement at an early age. The most distinct difference between the two types of accounts is when the tax advantages kick in.

Tax-deferred accounts

Tax-deferred accounts allow you to realize immediate tax deductions up to the full amount of your contribution, but future withdrawals from the account will be taxed at your ordinary income rate. The most common tax-deferred retirement accounts in the U.S. are traditional IRAs and 401(k) plans. In Canada, the most common is a registered retirement savings plan (RRSP).

Essentially, as the name of the account implies, taxes on income are "deferred" to a later date.

If your taxable income this year is $50,000, for example, 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 is initially $40,000, but you decide to withdraw $4,000 from the account, your taxable income would be bumped up to $44,000.

In 2020, individuals are allowed to contribute as much as $19,500 to a 401(k) plan, plus a $6,000 catch-up contribution if you're 50 or older.

In both 2019 and 2020, you can contribute a maximum of $6,000 to a traditional IRA (those 50 or over can add an additional $1,000). Participation in a workplace plan and the amount you earn may also reduce the deductibility of some of your traditional IRA contributions.

Tax-exempt accounts

Tax-exempt accounts don't deliver a tax benefit when you contribute to them. Instead, they provide future tax benefits; 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 grow tax-free.

Your current and expected future tax brackets are the primary driving factors in determining which account is most suitable for your tax-planning needs.

Popular tax-exempt accounts in the U.S. are the Roth IRA and Roth 401(k). In Canada, the most common is a tax-free savings account (TFSA).

If you contribute $1,000 into a tax-exempt account today and the funds are invested in a mutual fund that provides a yearly 3% return, in 30 years the account would be valued at $2,427. When you take out the money at retirement, you won't pay taxes on any of it.

By contrast, in a regular taxable investment portfolio, the owner would pay capital gains taxes on that $1,427 of growth when they sold the investments. And with a tax-deferred account, the owner would pay ordinary income tax when they took distributions from their account—contributions or earnings. Note that the long-term capital gains tax is lower than regular income tax.

With a tax-deferred account, taxes are paid in the future, but with a tax-exempt account, taxes are paid right now. However, by shifting the period when you pay taxes and allowing for tax-free investment growth, major advantages can be realized.

“I like to describe a tax-deferred account as really being tax-delayed. Taxes will be paid someday down the road. A tax-exempt account, however, is tax-free after the money is deposited into the account,” says Mack Courter, CFP®, founder of Courter Financial, LLC, in Bellefonte, Pa.

Contribution limits for Roth IRAs and Roth 401(k)s are the same as for traditional IRAs and 401(k)s, but people whose modified adjusted gross income (MAGI) is too high may not be able to contribute to Roth IRAs.

Benefits of Tax-Deferred Accounts

The immediate advantage of paying less tax in the current year provides a strong incentive for many individuals to fund their tax-deferred accounts. The general thinking is that the immediate 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 typically strongly encouraged to max out their tax-deferred accounts to minimize their current tax burden.

Also, by receiving an immediate tax advantage, investors can actually put more money into their accounts.

Let's assume, for example, that you are paying 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 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 can provide tax benefits and peace of mind.

Benefits of Tax-Exempt Accounts

Because the benefits of tax-exempt accounts are realized as far as 40 years into the future, some people ignore them. 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.

By opening a tax-exempt account and investing the money into the market, an 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 retirement will not push you into a higher tax bracket.

“The conventional belief that taxes will be lower in retirement is outdated,” says Ali Hashemian, MBA, CFP®, president of Kinetic Financial in Los Angeles, Calif. “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,” says Wes Shannon, CFP®, founder of SJK Financial Planning, LLC, in Hurst, Texas. “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 the ideal tax optimization strategy would involve maximizing contributions to both tax-deferred and tax-exempt accounts, there are certain variables to consider if such allocations are not possible.

Low-income earners

Low-income earners are encouraged to focus on funding a tax-exempt account. At this stage, contributions to a tax-deferred account would not make much sense seeing as how the current tax benefit would be minimal but the future obligation might be large.

Someone who contributes $1,000 into a tax-deferred account when they incur a 12% income tax would only save $120 today. If those funds are withdrawn in five years when the person is in a higher tax bracket and pays a 32% income tax, $320 will be paid out.

On the other hand, contributions to a tax-exempt account are taxed today. But, assuming that you will be exposed to a higher tax bracket in subsequent years, your future tax bill will be minimized.

High-income earners

Higher-salary earners should focus on contributions to a tax-deferred account such as a 401(k) or traditional IRA. The immediate benefit can lower your marginal tax bracket, resulting in significant value.

Consider the purpose and time frame of your retirement savings

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 most 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,” says Marguerita Cheng, CFP®, CEO of Blue Ocean Global Wealth in Gaithersburg, Md. “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 would be able to help you decide which type of account is best for you.

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 paying taxes, and depending on the type of account, it's simply a question of when.