Tax-Deferred vs. Tax-Exempt Retirement Accounts

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 account minimize the amount of lifetime tax expenses someone will incur. This provides 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.

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. Then, 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 The primary benefit of the tax-exempt structure is that investment returns grow and can be withdrawn entirely tax free.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," says Mack Courter, CFP®, founder of Courter Financial, LLC., in Manteo, Nc. "Taxes will be paid someday down the road. A tax-exempt account, however, is tax-free after the money is deposited into the account."

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 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.

For 2022, you can contribute up to $20,500 to a 401(k) plan, a $6,500 catch-up contribution if you're age 50 or older. In 2023, those numbers increase to $22,500 and $7,500.

In 2022, you can contribute a maximum of $6,000 to a traditional IRA (those 50 or over can add an additional $1,000). In 2023, the contribution limit is $6,500, plus an additional $1,000 in catch-up contributions if you are age 50 or older.

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

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).

Contribution limits for Roth IRAs and Roth 401(k)s are the same as for traditional IRAs and 401(k)s.

So, for 2022, you can contribute a maximum of $6,000 to a Roth IRA, and in 2023 you can contribute a maximum of $6,500. Those 50 or over can add an additional $1,000. However, people whose modified adjusted gross income (MAGI) is too high may not be able to contribute to Roth IRAs.

For 2022, you can contribute up to $20,500 Roth 401(k) plan. plus a $6,500 catch-up contribution if you're age 50 or older. In 2023, those contribution limits increase to $22,500 and $7,500, respectively.

If you contribute $1,000 to 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.

Capital Gains

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. Owners of a tax-deferred account would pay ordinary income tax on contributions and earnings when they took distributions from their account. Note that the long-term capital gains tax is lower than the regular income tax.

Benefits of Tax-Deferred vs. Tax-Exempt Accounts

Tax-Deferred 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.

Tax-Exempt Accounts

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. 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,” says Ali Hashemian, MBA, CFP®, CEO of Kinetic Investment Management 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 because the current tax benefit would be minimal, but the future obligation might be large.

Someone who contributes $1,000 to 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. So, if you do happen to be in a higher tax bracket in later years, it won't affect withdrawals from a tax-exempt account.

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 their marginal tax bracket, resulting in significant value.

Special Considerations

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," 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 can 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 going to pay taxes. Depending on the type of account, it's simply a question of when.