The Difference Between Tax-Deferred and Tax-Exempt Retirement Accounts
The Difference Between Tax-Deferred and Tax-Exempt
At The Income Tax Center, we want to help you prepare your income (and taxes) for every stage of life! Although it might be difficult to imagine it now, one day you will need to stop working and live off your retirement and savings. It can be a scary experience not having any income to retire, or simply not knowing what the best options are for retirement accounts.
Fortunately, various retirement accounts are easy to use and can help you save big on your retirement. These are known as tax-deferred and tax-exempt retirement accounts and are a very popular choice for tax-paying Americans. To find out about both and see which account is right for you, and to help you prepare for the future, read on below to find out more!
What is a Retirement Account?
A retirement account is, simply put, any account that you contribute a portion of your salary to save for retirement. There are a plethora of different retirement plans and accounts out there recognized by the Internal Revenue Service.
And much, much more! Retirement accounts typically vary based on what type of company you work for, whether you’re an employee, or you’re self-employed. Employers typically offer perks with getting hired, such as matching your contribution.
For instance, let’s say you deduct 5% of your check into your 401 (k) plan. If you get paid biweekly, as most Americans do, and make $2,000 a paycheck, then you contribute $100 a paycheck toward your retirement plan. Your employer would then contribute another $100, called matching your contribution, in essence doubling your savings.
There is one catch, however: you can’t access your money for at least a couple of years, known as the vesting period. For instance, if you quit before 3 years, you still keep the money you contributed into your (401)k, just not the money your employer contributed. This is a benefit to working for a big company, and one of the incentives employers use to keep you employed for a certain amount of years!
However, pulling out your money later on after retirement isn’t a bad thing, and in fact, can mean huge savings in the form of a tax-deferred retirement account and savings.
What if I want to Pull Out Money Now?
If you want to pull money out of your 401 (k) or other retirement accounts, you must be able to meet certain criteria as deemed eligible by the IRS. These include:
If you’re under the age of 59 ½ and want to pull out money but don’t meet these criteria, it’s best to talk to a financial expert to weigh your options. Pulling out money from your retirement account could incur a 10% fee.
Just the opposite is true also, as people 72 years and older must start taking payments out of their account, known as a required minimum distribution. This helps avoid people from not paying taxes on their income.
What is a Tax-Deferred Account?
A tax-deferred account is a retirement account where the money that is invested into the account isn’t taxed until after it is withdrawn. Usually, this is done after retirement.
The money that is placed into the account won’t be taxed right then and there, and it is still able to be written off your gross income tax. This means that if you make $70,000 a year, and contribute $10,00 into your retirement account, you will only pay $60,000 in taxes.
However, when you retire, your payments from that tax-deferred account will be taxed like regular income. For instance, if you make an income of around $40,000, and take out $2,000 from your tax-deferred account, you will be taxed at $42,000 for the year.
In essence, you’re simply pushing back taxes until you retire. Some of the most popular accounts in the United States for tax-deferred retirement include:
What is a Tax-Exempt Account?
A tax-exempt account can be thought of as the opposite of a tax-deferred account. This means that instead of your contributions being taxed later on after retirement, they are taxed the moment you put them into your account and cannot be written off your gross annual income.
Once you retire and pull out funds from your tax-exempt account, you no longer have to pay taxes on it like you would with a tax-deferred account.
Some of the more popular options for tax-exempt accounts include:
It’s important to note that Roth IRA and Roth 401(k) accounts aren’t for everyone, and people with a modified adjusted gross income that’s too high won’t be able to contribute to a tax-exempt account. As of 2020:
If you’re over this income limit, don’t worry, as you can still contribute to a Roth IRA through a loophole.
What are the Benefits of Each?
Both tax-deferred and tax-exempt accounts have their benefits, and both provide an opportunity for people to save for retirement and ensure they live comfortably after they can no longer work.
For tax-deferred accounts, being tax-deferred until after retirement has immediate tax savings and benefits, such as subtracting your contributions directly from your MAGI. For high-income earners, this is a great opportunity to save during tax time and re-invest more of their income into their retirement savings.
The benefits of a tax-exempt account might seem distant, as you’re being immediately taxed and won’t enjoy the “tax-free” life until after retirement. However, more and more people are starting to prefer investing in Roth-IRA’s and Roth 401 (k) accounts.
The reason is that when you invest into a Roth IRA, your money is already taxed before going into the account, meaning it can’t be taxed again when you take it out after retirement. By choosing the right investments in your Roth IRA account, such as stock mutual funds, your money will grow while it is in the account, and won’t be taxed no matter how much it has grown!
For instance, let’s say you invested $1,000 after taxes into your Roth IRA. Through investments and having your money work for you in the account, this investment can grow to $2,500. Since you already paid taxes on this money, that means all your profits are tax-free, meaning the $1,500 that was added on to your initial investment!
How can I Choose?
Whether you choose to invest into a traditional or Roth IRA or other retirement accounts, it’s important to remember that contributions can be capped based on your filing status, age, and income.
According to the IRS, for the years of 2021, 2020, and 2019, the total contributions you make each year to any Roth IRA or traditional IRA accounts can’t exceed the combined limit of:
Although a tax expert and financial advisor are the best people to talk to about choosing a retirement account, the general consensus is that your predicted income bracket when you retire will determine what retirement account you choose.
For low-income earners, contributing to a tax-exempt account is the smart choice. In the future when you fall into a higher-income bracket, your taxes will be minimized and lead to future savings.
For high-income earners, a tax-deferred account is a great choice to get the most tax savings in the form of tax write-offs to MAGI, leading to a significant reduction in taxes and possibly a change in tax bracket.
Speak to a Tax Expert Today
If all this seems confusing, it’s okay to feel a little overwhelmed. However, don’t put off saving for retirement simply because you don’t know how it works.
At The Income Tax Center, we strive to help you save as much as you can on taxes, and ensure every penny possible is put into your pocket. Call us today for financial advice on retirement or other tax questions, at (314) 209-8299.
Income Tax Preparation | 10/18/2021