Tax planning is a significant factor in choosing which type of retirement account best fits your financial goals. Tax-deferred and tax-exempt accounts may help you minimize your tax responsibility. While these retirement accounts handle taxes differently, both can help you retain more wealth over your lifetime.
The advantages of tax-deferred and tax-exempt retirement accounts come into effect at different times. Understanding the critical differences between these accounts helps you make the best decision for your retirement funds.
Tax-Deferred vs. Tax-Exempt Retirement Accounts
Paying income taxes on your retirement funds is unavoidable. However, strategically choosing where you place your assets can significantly reduce your tax burden over your lifetime. Tax-deferred and tax-exempt retirement accounts receive different tax treatments, which may make one a more appealing option for retirement savings.
Tax treatment can play a significant role in your retirement savings. A strategic asset location plan can provide several benefits for your funds, whether you place them in a tax-deferred or tax-exempt account.
Tax-Deferred Retirement Accounts Overview
The primary difference in tax-exempt vs. tax-deferred retirement accounts is when the tax advantage comes into effect. Tax-deferred retirement accounts provide an immediate tax benefit by deferring income taxes until you make a withdrawal. Since money in a tax-deferred retirement account accumulates interest on pre-tax amounts, account owners benefit from tax-free contributions and pay taxes later.
Another significant difference between tax-deferred vs. tax-exempt retirement accounts is when account owners can take tax deductions for their retirement contributions. Tax-deferred retirement accounts enable account holders to take tax deductions immediately, up to the total amount they’ve contributed to their accounts.
The types of tax-deferred retirement accounts include:
A traditional individual retirement account (IRA) is a tax-deferred IRA that enables tax-deductible contributions. Features of traditional IRAs include:
- Pre-tax investments: Funds in a traditional IRA are not subject to tax until the account owner takes a withdrawal.
- Tax deductions: A traditional IRA enables fully or partially deductible contributions.
- Limited contributions: Tax-deferred IRA rules stipulate that people can only contribute up to the annual $6,000 limit. If someone participates in a workplace-sponsored retirement plan or makes above a specific amount, contributions to a traditional IRA may be limited.
- Minimum distributions: Traditional IRAs are also subject to required minimum distributions (RMDs), which usually begin when the account owner turns 72.
Most traditional IRAs are conventional, meaning a brokerage house manages the funds for the account owner. People who want more control over their traditional IRAs may choose to open a self-directed IRA instead.
Self-directed IRAs can be traditional or Roth accounts. These accounts function differently than conventional IRAs — owners of self-directed IRAs direct their funds through a broker or account custodian and have greater flexibility when choosing their investments.
The same annual contribution limits apply to self-directed IRAs as to conventional IRAs. However, self-directed IRAs allow the owner to invest in alternative assets like real estate, gold or private equity.
Another type of tax-deferred retirement account is the 401(k), which allows employees to contribute a portion of their wages to the account. Most 401(k)s are employer-sponsored retirement accounts, so account owners must go through their employer to make contributions. As with traditional IRAs, 401(k)s are subject to RMDs beginning when the account holder turns 72.
Although most 401(k)s are employer-sponsored, those who are self-employed or whose employer doesn’t provide the option can still open a self-directed 401(k). This type of 401(k) removes the need for an employer, giving the account owner more control over their investments.
Tax-Exempt Retirement Accounts Overview
While tax-deferred retirement accounts provide a tax break on retirement contributions, tax-exempt accounts offer tax benefits upon withdrawal. When someone opens a tax-exempt retirement account, they pay income taxes on their money before making contributions. Since tax-exempt retirement accounts use post-tax dollars, these accounts are entirely tax-free once the money is deposited. Although there isn’t an immediate tax advantage for these accounts, they allow income to grow without ever being taxed again.
Here are the two types of tax-exempt retirement accounts:
Roth IRAs are tax-exempt retirement accounts that allow owners to make tax-free withdrawals. Roth IRAs are subject to the same annual contribution limits as traditional IRAs. However, since Roth IRAs are not subject to RMDs, you’ll never be required to take a distribution. Additionally, Roth IRA account owners must meet federal income limits to make contributions and can’t deduct contributions from their taxes.
Roth IRAs may be conventional — where a brokerage house guides investments — or self-directed. Opening a self-directed Roth IRA gives account owners more control over their investments and diversifies their portfolios more broadly.
A Roth 401(k) is another retirement account the owner funds with after-tax dollars. This type of retirement account combines many features of those above:
- Qualified distributions are tax-free.
- There are no income limits for someone to open a Roth 401(k).
- Roth 401(k)s are subject to RMDs.
- Self-directed Roth 401(k)s give account owners the flexibility to invest in real estate, precious metals, cryptocurrencies and more.
Factors to Consider Before Opening an Account
When comparing tax-deferred vs. tax-free accounts, it’s essential to consider your financial situation and goals. One account may help you maximize your wealth better than another, and some retirement accounts have limitations you may want to avoid. Here are a few factors to consider before deciding which retirement account is best for you:
1. Current and Future Taxable Income
Many people are drawn to the immediate tax benefit of a tax-deferred IRA or other tax-deferred retirement accounts. These accounts are often beneficial for high earners. A tax-deferred account minimizes their current taxable income, while a tax-exempt account requires them to pay the total income tax for their tax bracket.
Future taxable income is another crucial consideration. Since many people have a lower taxable income after they retire, paying income taxes during retirement may significantly reduce their tax burden.
2. Investment Goals
Some investors are buy-and-hold, while others are more active and prefer an aggressive approach. Keeping your investment goals in mind is essential when selecting a retirement account. Tax-exempt accounts may appeal more to aggressive investors because they can realize tax-free capital gains.
Self-directed retirement accounts are ideal for active investors. These accounts give you more control over your investments and allow for a broader investment portfolio.
3. Required Minimum Distributions
RMDs may be another factor to consider when deciding on a retirement plan. While owners of traditional IRAs, 401(k)s and Roth 401(k)s must begin taking distributions at 72, Roth IRA account owners are not required to do so.
Open a Tax-Deferred or Tax-Exempt Account Today
Tax planning is crucial for making decisions about your retirement and investments. A tax-deferred or tax-exempt retirement account may help you achieve your financial goals.
If you want to invest your retirement account funds in non-traditional investment options, going through a bank or brokerage firm may not give you the options you want. At Accuplan, we offer self-directed tax-deferred and tax-exempt retirement plans that take your investment opportunities to a new level. With a self-directed retirement plan, you can invest in what you’re passionate about.
Our information should not be relied upon for investment advice but simply for information and educational purposes only. It is not intended to offer, nor should it be relied on for, legal, accounting, investment or tax advice.