Saving for retirement is a crucial financial step. The good news is, many different retirement accounts come with tax benefits. You'll need to make sure you choose the best one for your situation, which means understanding how different kinds of tax breaks work.
Specifically, it's important to know the difference between accounts offering tax-deductible contributions, tax-deferred growth, and tax-free withdrawals.
Here's what you need to know about these different kinds of tax-advantaged accounts so you can make smart choices about investing money for retirement.
Tax-deductible vs. tax-deferred vs. tax-free
Retirement accounts can provide different kinds of tax benefits. Some allow tax-deductible contributions, most allow tax-deferred growth, and some allow tax-free withdrawals. But what do each of these terms mean?
Here are quick definitions of tax-deductible, tax-deferred, and tax-free:
- Tax-deductible: This means you can claim a deduction on your taxes for contributions. Deductions reduce your taxable income. For example, if your taxable income was $40,000 and you made a $1,000 tax-deductible contribution to your retirement account, you would be taxed only on $39,000 in income instead of $40,000.
- Tax-deferred: This means that you pay taxes at a later point. For example, if you invest in a retirement account that allows for tax-deferred gains, your money grows tax-free, and you pay taxes only when you make withdrawals from your account.
- Tax-free: Tax-free means that you do not owe income taxes at all. Some retirement accounts allow tax-free withdrawals, so you can take money out of your retirement savings account and not owe anything to the IRS.
The best tax software can help you calculate what deductions you are entitled to and when you owe taxes versus when your income is tax-free.
How tax-deferred accounts work
Tax-deferred retirement accounts allow you to make pre-tax contributions, meaning you haven’t paid income taxes on your contributions yet. Instead, taxes are deferred, or put off until later. You typically don’t pay taxes on the money in a tax-deferred retirement account until you begin taking withdrawals in retirement.
In most cases, contributions to tax-deferred accounts are also tax-deductible. That means that you can make a contribution and deduct the amount you contributed from your current year’s taxable income.
For example, in 2023, if your income doesn’t exceed allowable thresholds, you can contribute up to $6,500 to a traditional IRA, or up to $7,500 if you are 50 or over. Traditional IRA contributions are generally tax-deductible. So if you contributed $6,500 and had a taxable income of $50,000 before your contribution, that contribution would reduce your current year’s taxable income to $43,500.
The tax benefits that come from deductible contributions and deferred growth can be very valuable. For example, if you are in the 22% tax bracket and make a $6,500 contribution, you could save up to $1,430 on your taxes (6,500 x .22 = 1,430). Due to that $1,430 tax savings, your $6,500 contribution would effectively cost $5,070 (6,500 - 1,430 = 5,070).
Typically, IRS rules limit when you can begin withdrawing money from tax-deferred accounts. If you start taking withdrawals too soon (before age 59 ½) and you don't qualify for an exemption (such as for specific kinds of financial hardship), you could owe a tax penalty on top of ordinary income taxes.
Types of tax-deferred retirement accounts
There are many different examples of tax-deferred retirement accounts, each with specific requirements and contribution limits, including:
- 401(k) accounts
- 403(b) accounts
- Traditional individual retirement accounts (IRAs)
- Tax-deferred annuities
- Simplified Employee Pension Plans (SEP IRAs)
- Savings Incentive Match Plans for Employees (SIMPLE IRAs)
Some accounts, such as 401(k)s, may also come with other perks, such as an employer match. If your company offers this, your employer will match your contributions according to the rule they set. For example, they might match 50% of the amount you contribute, up to 6% of your salary.
You can open certain types of tax-deferred retirement accounts, like a traditional IRA or self-employed 401(k), with almost any brokerage firm. If you are contributing to an employer-provided account, your employer will control what financial institution manages your account.
Benefits of tax-deferred accounts
There are many benefits of tax-deferred accounts, including the following:
- Some accounts, such as 401(k)s, have high contribution limits, and you can contribute regardless of income.
- You can benefit from tax deductions for your contributions, reducing your tax liability in the current year.
- Your employer might make contributions on your behalf to certain employer-sponsored tax-deferred accounts, such as 401(k), SIMPLE, and SEP IRAs.
- You do not have to pay taxes on investment gains as your money grows, so your money can be reinvested to earn potential returns for you.
Drawbacks to tax-deferred accounts
There are also some downsides to tax-deferred accounts:
- You will be required to take required minimum distributions (RMDs) starting at age 72. This means you must take a certain amount of money out each year, as determined by the IRS. The IRS wants to collect taxes eventually, so you can't leave the money in the account indefinitely and defer taxes forever.
- In most cases, if you take money out before 59 ½, it will result in a hefty tax bill. You’ll be taxed at your ordinary income tax rate plus owe a 10% penalty.
- You will be taxed on your withdrawals when you retire. This reduces the income available to you.
- Withdrawals from tax-deferred retirement accounts count as income when determining if Social Security benefits become taxable (unlike withdrawals from tax-free accounts). As a result, choosing tax-deferred accounts could lead to owing tax on Social Security retirement benefits if your income is too high.
How tax-free accounts work
Some accounts allow you to take money out tax-free. For example, you won’t owe taxes on distributions from a Roth 401(k) or a Roth IRA in retirement as long as you’re over age 59 ½ and your account has been open for five years.
Your contributions to these tax-exempt accounts are generally not tax-deductible in the year you make them, though. You contribute to them with after-tax dollars, which means you’re paying taxes on them upfront rather than deferring them until retirement.
That said, there’s one type of account that you can make tax-deductible contributions to and take tax-free withdrawals from. It's called a health savings account (HSA), and it's designed to allow you to pay qualifying healthcare expenses without being taxed on the money. However, to be eligible for an HSA, you need a high-deductible health plan. And withdrawals are tax-free only if you use them to cover a qualifying medical expense.
Types of tax-free accounts
Examples of accounts that may allow tax-free withdrawals include:
- Roth 401(k)s
- Roth IRAs
Benefits of tax-free accounts
There are some benefits of tax-free retirement accounts to consider, including the following:
- You may not need to take RMDs. Roth IRAs do not require them, although Roth 401(k) accounts do.
- You may be eligible to withdraw contributions at any time without an early withdrawal penalty. This offers more flexibility as far as accessing your money. For example, with a Roth IRA, you can take out the money you put in without being taxed on it, although you are taxed on any withdrawn gains.
- You can avoid owing taxes as a retiree, which may include avoiding taxes on Social Security benefits. Distributions from Roth accounts don't count as income in determining if Social Security benefits are taxed.
Drawbacks to tax-free accounts
There are some downsides to tax-free accounts as well, though:
- Many accounts have limited eligibility. For example, Roth IRAs have stricter income limits than many other types of retirement accounts, such as 401(k)s and SEP or SIMPLE IRAs. And HSAs are only available to people with high-deductible health plans.
- Contributions are generally not tax-deductible, except in the case of HSAs.
- Fewer employers provide access to Roth 401(k)s vs. traditional 401(k) accounts.
- You are subject to early withdrawal penalties if you withdraw investment gains from these accounts, so you don't have as much flexibility as with taxable brokerage accounts.
Which type of account makes sense for you?
The right type of retirement savings account for you will depend on your financial situation and preferences.
When you're saving for retirement, consider whether you expect your tax rate to be higher or lower in retirement than it is now. If you expect to be in a lower tax bracket in retirement, it could make sense to open a tax-deferred account like a traditional IRA and put off your tax payment until later, when you can be taxed at that lower rate.
However, if you expect to be in a higher tax bracket when you retire, opening a tax-free account like a Roth IRA may make more sense and ultimately result in tax savings. If you have questions about which type of account makes the most sense, consider speaking with a financial advisor to get help with retirement planning.
What's better, a tax-deferred or tax-free account?
There's no one right answer to which account type is better. You may prefer a tax-deferred account if you expect your tax bracket could be lower later in life. In this case, it would make sense to wait to pay your taxes until your rate has fallen.
But you may prefer an account offering tax-free withdrawals if you expect your tax rate will go up or if you worry about being taxed on Social Security benefits.
Should you have both a tax-deferred and tax-free account?
It could make sense to have both a tax-deferred and a tax-free account for your retirement plan. For instance, you might contribute to both a 401(k) through your employer and a Roth IRA account.
Doing so could help you grow your retirement savings over time, more so than just contributing to one type of account. Plus, you might get the advantage of an employer match with a 401(k) and the benefits of tax-free retirement income with a Roth IRA.
Do you get taxed on health savings accounts?
Whether you are taxed on health savings accounts depends on how you withdraw money from them.
If you have a qualifying high-deductible health plan and are eligible for an HSA, you can make tax-free contributions to the account. And as long as you withdraw money to cover qualifying healthcare expenses, you will not be taxed on withdrawals.
However, if you take money out for purposes other than covering health expenses, you will owe taxes on the distribution at your ordinary rate. And if you’re under age 65 when you make a withdrawal for something other than medical expenses, you’ll owe a 20% penalty on top of your regular taxes.
Creating a strategic retirement savings plan is a key part of learning how to manage your money. Now that you know the difference between tax-deferred, tax-deductible, and tax-free accounts, you can make the most informed choices about what kind of retirement investment account is best for you.
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