What Is the Difference Between Tax-Free Investments & Tax-Deferred Investments?

Tax-free and tax-deferred are two terms that get thrown around quite often in the financial world but can sometimes confuse new investors. While they’re similar, the primary difference between tax-free and tax-deferred investments is when you pay taxes on those funds.

We understand that these terms can be a little misleading, so we’ve put together this simple rundown on tax-free vs. tax-deferred investments to make your retirement planning a little easier.

Let’s Just Say It – Neither Option Means “Zero Taxes”

Despite the potentially misleading names, you will be paying taxes on tax-free and tax-deferred investments. Don’t worry, we were upset when we found out too.

With a “tax-free” investment, you pay taxes on the funds when you make the investment. However, once you reach retirement age and withdraw the funds, you won’t have to pay any further taxes.

On the other hand, a tax-deferred investment is one where you don’t pay any taxes on the income at the time of the investment or while that investment grows. You are taxed only when you withdraw funds from the account.

Usually, these tax-advantaged opportunities are only available in retirement savings accounts such as IRAs or 401(k)s.

Popular Options for Retirement Accounts

Many people opt for at least one of a few popular options when choosing an investment account for their retirement.

Many choose an employer-sponsored 401(k) account, which offers additional benefits such as contribution matching by their employers up to a certain percent of salary or an annual dollar cap.

Others prefer to invest in an IRA and personally manage their contributions to the account. The primary downside is that they won’t have employer contribution matching. However, IRAs are an excellent choice for those who want more personal control over their retirement investments.

IRAs and 401(k)s offer tax-deferred and tax-free investment options.

Tax-Deferred Accounts and Investment Products

If you’re considering tax deferment for your retirement investments, compare the potential benefits of these account types:

• Traditional IRAs
• Simplified Employee Pension Plans (SEP IRAs)
• Savings Incentive Match Plans for Employees (SIMPLE IRAs)
• 401(k) accounts
• 403(b) tax-deferred annuities
• Other tax-deferred annuities

Different benefits and purposes exist for each of these account types. For example, SIMPLE IRAs are often a choice for small business employees, similar to a traditional IRA. By contrast, a tax-deferred annuity is a personal retirement plan to supplement your employer’s base retirement package.

You may want to consult with your employer’s HR department to learn more about what retirement plans and investment opportunities it offers before choosing an option. Additionally, consider speaking with a knowledgeable financial adviser about investing for retirement.

Tax-Free Accounts and Investment Products

If you want to research tax-free accounts for your retirement investments, consider one of these account types:

• Roth 401(k) accounts
• Roth IRAs
• HSAs

You might be asking, “What is an HSA?” An HSA is a Health Savings Account, an investment account to save for future medical procedures for which you can qualify if your health insurance plan has a high deductible. Qualifying medical withdrawals are tax and penalty-free. Any withdrawals made for non-medical reasons before age 65 are subject to taxes and a 20% penalty.

How Does Tax Deferment Work?

Tax deferment simply means that you qualify for tax deductions upon depositing into your investment account and will pay taxes on any funds you withdraw from your investment account later. What does that mean for your investment?

1. You qualify for an income tax deduction when you contribute to a tax-deferred account.
2. You don’t pay taxes on dividends or capital gains while your investment grows in the account.
3. You only pay an income tax when withdrawing from the account, usually after retirement.

While it may seem an easy choice to make to spend no money now to be able to start investing immediately, a tax-deferred account is a better choice than a tax-free one in some instances.

The primary benefit of a tax-deferred account is when you suspect you’re in your peak earning years since you can put off taxes on your retirement investing account until after lowering your income and slipping into lower tax brackets.

“But why would I wait until I earn less to pay taxes on my investments?” Let’s see how a Traditional IRA works with tax deferment of a contribution amount of $6,000 while in the 24% tax bracket at the time of contribution and 12% at the time of retirement. Additionally, let’s assume that you’re 45 years old and will collect at 65 (20 years) with a return of 10% on your investments.

Whether you pay your taxes on contribution or withdrawal, you want taxes to apply when you earn less and are in a lower tax bracket if you intend to withdraw from your retirement investment account. The IRS may require you to withdraw from your tax-deferred retirement account to ensure you pay taxes on those funds, but we’ll discuss that later.

So that’s how tax deferment works. But what about tax-free retirement accounts?

What Is a Tax-Free Investment Account?

If you want to rip the bandage off immediately and pay your taxes upon contribution so that you don’t have to pay them later during withdrawal, you want a tax-free investment account. Your contributions will grow more slowly, but you don’t have to worry about taxes on your investments after your initial contribution.

So let’s use the same numbers from our last example but apply the taxes at contribution rather than withdrawal to find what a Roth IRA would earn under the same conditions as a Traditional IRA.

That’s a contribution amount of $6,000, while in the 24% tax bracket at the time of contribution, and 12% at the time of retirement. Additionally, let’s assume that you’re 45 years old and will collect at 65 (20 years) with a return of 10% on your investments.

As you can see, the final value of the investment account is lower than in our example for a Traditional IRA with tax deferment. However, the conditions under which you choose your retirement account would vary depending on your situation.

Many young people who have recently entered the workforce typically earn in a lower tax bracket. They may choose a Roth IRA over a Traditional IRA once they start earning enough to pay their bills and have money left over at the end of the month. Let’s run another simulation for one of these young earners.

For our example of a typical Roth IRA earner, let’s assume a contribution amount of $3,000 while in the 12% tax bracket at the time of contribution, and 24% at the time of retirement. Also, let’s assume an age of 25, collecting at 65 (40 years) with a return of 10% on investments.

Depending on your income, where you are in your career at the moment, and when you plan to retire, you may find benefits to tax-free retirement accounts over tax-deferred accounts to invest for retirement.

Are There Tax Advantages for a Tax-Deferred Account?

Several tax advantages exist for tax-deferred accounts, including:

• Tax deductions on income taxes. You can get qualified tax deductions for contributions you make to tax-deferred accounts for each year you contribute, reducing the income taxes you owe. You could use these deductions to qualify for lower tax brackets.
• Lower tax responsibilities in retirement. If you are currently at your highest earning potential, you’re also at your highest tax potential. You can defer taxes on a portion of your income until retirement, when you likely qualify in a lower tax bracket to pay less on withdrawals than on contributions with a tax-free account.
• Some accounts have high contribution limits. 401(k)s and some other tax-deferred accounts will allow you to contribute more of your income than others.
• Employers can contribute. 401(k)s, SIMPLE IRAs, and SEP IRAs can receive employer-matching contributions to your retirement investment accounts.
• Tax-free reinvestment. You won’t pay investment or capital gains on your investments, allowing you to reinvest your funds to earn greater returns.

Potential Downsides of a Tax-Deferred Account

Choosing tax deferment can pose a few issues during your retirement or when passing an account to beneficiaries, including:

• The IRS requires that you withdraw funds from a tax-deferred account beginning at age 72. These required minimum distributions (RMDs) ensure that the IRS receives its taxes due since you elected to defer payment on these funds.
• If you withdraw early (before age 59 and a half), you will owe up to a 10% penalty in addition to your deferred taxes.
• Withdrawals count as income, which could put you over the threshold for Social Security benefits if you have early retirement before reaching your full retirement age for Social Security.
• Beneficiaries of a tax-deferred account like a Traditional IRA may face restrictions on when and how they can withdraw funds after you pass away. They will still owe taxes on their withdrawals from the account.

Do Tax Advantages Exist for a Tax-Free Account?

Yes, you can gain some tax advantages for tax-free accounts, including:

• Required minimum distributions (RMDs) are not always required. Although Roth 401(k) accounts still require minimum distributions, Roth IRAs do not.
• Early withdrawal without penalties. You might be able to access your money without penalties for early withdrawal. However, you will still have to pay taxes on gains or investment earnings.
• Social Security benefits. Roth account withdrawals don’t count as ordinary income to qualify for Social Security benefits in retirement.
• Beneficiaries paying no taxes on withdrawals. The beneficiaries you name to inherit your Roth IRA after your death will not owe taxes when withdrawing funds from the account since you paid taxes at contribution.

Potential Downsides of a Tax-Free Account

Some potential disadvantages to choosing a tax-free account for your retirement investments include:

• Limited eligibility for Roth accounts exist, with strict income limits compared to other investment accounts.
• Only people with high-deductible health plans qualify for HSAs.
• Contributions are not tax deductible, so you cannot lessen your tax responsibility or change tax brackets through contributions.
• Fewer employers offer contribution matching to tax-free Roth accounts.
• You may face penalties for withdrawing investment gains from a tax-free account.

It’s Not Just About Your Tax Burden: Beneficiaries of Retirement Accounts

When choosing what type of retirement account you want, remember that you can name beneficiaries to most retirement account types or add your retirement account to a trust. How do you want your investment to benefit your loved ones?

While you may be able to build a larger account balance in a tax-deferred account, your beneficiaries may face restrictions on when they can withdraw their funds, as well as having to pay taxes on funds withdrawn.

If you want to begin building generational wealth for your family, a Roth IRA may accumulate more slowly, but you ensure that your loved ones can receive the full value of the account when they withdraw their inheritance by paying taxes at contribution.

Can You Invest in Both Tax-Free and Tax-Deferred Accounts?

If you see the value in different aspects of each type of account, you may choose to manage your retirement with multiple tax-free investments and tax-deferred investments to suit different retirement needs. For example, if you already have a Roth IRA early in your career and now earn much more, you might choose a Traditional IRA to maintain your income during retirement with RMDs.

You may also want multiple account types to withdraw without penalties if you ever find that you need some quick cash but limit which funds you can withdraw so you can’t deplete your retirement investments.

Make Tax-Deferred Investments In A Crypto IRA

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