Tax-Deferred vs. Tax-Exempt Retirement Accounts (2024)

Whenchoosing the best type of retirement accountforyour financial goals,you may want to minimize your tax obligations. Tax-deferred andtax-exempt accountscan help you retain more wealth over your lifetime.However, each ofthese retirement accounts handles taxes differentlyand hasadvantages at different times. Understanding the differences between these accounts helps you make the best decision for your retirement funds.

What AreTax-Free vs. Tax-DeferredAccounts?

You will payincome taxes on your retirement fundsone way or another.Tax-free accounts, also called tax-exempt accounts, are only tax-free on withdrawal and not when contributing, whereas tax-deferred accounts are the opposite.

However, strategically choosing where you place your assetsand when you pay tax on themcan reduce your lifetime tax burden. Tax-deferred and tax-exempt retirement accountsboth offer taxbenefitsbutreceive different tax treatments, which may make one more appealing foryourretirement savings.

Tax-Deferred Retirement Accounts Overview

Themaindifference in tax-exempt vs. tax-deferred retirement accounts is when the tax advantageapplies. Tax-deferred retirement accounts provide an immediate tax benefit by deferring income taxes until youwithdraw. Since money in a tax-deferred retirement account accumulates interest on pre-tax amounts,youbenefit from tax-free contributions and pay taxes later.

Another significant difference between tax-deferredandtax-exempt retirement accounts is when owners canclaimtax deductions for their contributions. Tax-deferred retirement accounts enable account holders to take tax deductions immediately, up to the total amount they’ve contributed to their accounts.However, you must pay income tax when you withdraw, so remember to factor this into your retirement plans.

Thetypes of tax-deferred accountsincludetraditional IRAs and 401(k)s.

Traditional IRAs

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 areonly taxed whenthe account owner takes a withdrawal.
• Tax deductions:A traditional IRA enablesfully or partially deductiblecontributions.
• Limited contributions:Tax-deferred IRA ruleslimit annual contributions, though people aged 50 and overhave an additional “catch-up” limiton top of that. 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 torequired minimum distributions (RMDs)oncethe account owner turns 72.This means you must start withdrawing a minimum amount from your account at that time.

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 maypreferaself-directed IRAaccount.

Self-directed IRAscan betraditional or Rothaccounts. 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 IRAsandconventional IRAs. However, self-directed IRAs allowyoutoinvest inalternative assetslike real estate, gold or private equity.

401(k)s

Another type of tax-deferred retirement account is the 401(k), which allows employees tocontribute a portion of their wagesto the account. Most 401(k)s areemployer-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.However, they have higher contribution limits, allowing you tosave funds more rapidlytoward retirement.

Although most 401(k)s are employer-sponsored, self-employedpeopleorthosewhose employer doesn’t provide the option can stillopen aself-directed 401(k)account. This type of 401(k)eliminates the employer’s role, giving the account owner more control over their investments.

Tax-Exempt Retirement Accounts Overview

Whileboth the majortax-deferred accounttypesprovide a tax break on contributions,tax-exempt accountsoffer tax benefits upon withdrawal.Simply put, tax-deferred means “save now, pay later,” and tax-exempt means “pay now, save later.”

Whenyouopen 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 onceyou depositthe money. Although these accountslack animmediate tax advantage, they allow income to grow without ever being taxed again.

The two types of tax-exempt retirement accounts areRoth IRAs and tax-exempt 401(k)s.

Roth IRAs

Roth IRAs are tax-exempt retirement accounts thatallowyouto maketax-free withdrawalsupon retirement or other qualifying circ*mstances. Roth IRAs are subject to the same annual contribution limits as traditional IRAs. However, since Roth IRAs are not subject to RMDs, youcan leave your money to grow as long as you like. Additionally, Roth IRA account owners mustmeetfederal income limitstocontributeandpay income tax on their contributions.

Roth IRAs may be conventional — where a brokerage house guides investments — orself-directed. Opening aself-directed Roth IRA accountgivesyoumore control overyourinvestments andbroader diversification.

Tax-Exempt401(k)s

A Roth 401(k) is another retirement accountyou fundwith after-tax dollars. This type of retirement account combines many features of those above:

• Qualified distributions are tax-free.
• There areno income limitsfor a Roth 401(k)account.
• Roth 401(k)s are subject to RMDs.
• These 401(k)s havethe same contribution limitsas traditional 401(k)s.
• 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, consider your financial situation and goals. One account may help you maximize your wealth better than another, and some have limitations you may want to avoid. Considerthe followingfactors before deciding which retirement account is best for you.

1. Current and Future Taxable Income

Many peopleenjoythe 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 taxable income,whereasa tax-exempt account requiresyouto pay thefullincome tax foryourtax bracket.Because of those immediate tax savings, you may be able to afford larger contributions during your working years, boosting your retirement savings progress. However, if your income is low right now, you may save more by paying taxes upfront and withdrawing tax-free when you retire.

Future taxable income is another crucial consideration. Since many people have a lower taxable income after they retire, paying taxeson withdrawalsduring retirementand reducing their taxable income nowmayminimizetheir tax burden.If you expect your income to increase over time, it may be wiser to choose a tax-exempt account so you can pay taxes while in a lower bracket and benefit from tax-free withdrawals later.

2. Investment Goals

Some investorslike holding assets for long-term growth, 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 accountsmay appeal more to aggressive investors because they canrealize tax-freecapital gainswhen selling assets.

Self-directed retirement accounts are ideal for active investors. These accounts give you more control over your investments and allow for a broader portfolio.

Whether you opt for a more conservative or aggressive investment strategy depends on your time horizon and preferences. In general, investors closer to retirement enjoy the security of a buy-and-hold approach, while those starting early have the risk tolerance to pursue higher returns with more aggressive strategies.

However, you may be an exception, depending on your temperament and circ*mstances. A self-directed account lets you take charge of your investment strategy, adapt to changing circ*mstances and diversify across asset classes to protect your funds.

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 ownerscan leave their investments to grow throughout their lives.This means you cansave your entire Roth IRAfor your family to inherit if you have enough retirement funds in your other accounts to cover your needs.

Although traditional IRAs, 401(k)s and Roth 401(k)s have RMDs from age 72, you canwithdraw without penalties from age 59 ½, and you may withdraw more than the minimum.

Open a Tax-Deferred or Tax-Exempt Account Today

Tax planning is crucial for your retirement and investment decisions. A tax-deferred or tax-exempt retirement account may help you achieve your financial goals.

If you want to invest your retirement funds inalternative assets like real estate, precious metals and cryptocurrencies, 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 plansto expandyour investment opportunities. With a self-directed retirement plan, you can invest in what you’re passionate about.

Our team at Accuplan has vast industry experience and knowledge to help youfund your retirement, your way.Create an accountorcontact us todayto get started.

Our information should not be relied upon for investment advice but simply for information and educational purposes only. It is not intended toprovide, nor should it be relied on for, legal, accounting, investment or tax advice.