Which accounts are better for your retirement?
Today, we offer a quick overview of tax-deferred vs. tax-free. Learn about how taxes and contributions work for each.
(The video is 4 minutes. Full transcript is below.)
Full Transcript of video
Hello, I’m Josh Duncan with SCB News bringing you this edition of Financial Freedom. The purpose of Financial Freedom is to provide tips to help you achieve financial freedom for personal significance.
What are these accounts?
The two most common accounts used to save for retirement are tax-deferred and tax-free. Some names the tax deferred accounts go by are traditional IRA, 401k, 403b, 457, and pre-tax. Tax-free accounts always include the name Roth. Let’s take a look at the differences between these options.
History of tax-deferred accounts
The journey for tax deferred accounts started in 1974 after the passing of the Employee Retirement Income Security Act. The addition of the Roth option was made in 1997 and named after Senator William Roth. As you can see, neither of these options have been in existence for very long. And, each was started to provide a way for and encourage Americans to save for retirement.
How tax-deferred contributions work
Tax-deferred contributions are made with income that has not yet had income tax paid. The money then grows within the account, still deferring tax. The only time tax is paid is when money is removed from the account. Investments can be sold with gains but without immediate tax implications.
If you are participating in your company’s retirement plan, they will make the tax-deferred contribution for you and figure the income tax withholding on the difference. If you are contributing to a traditional IRA, you will have to make the contribution and then claim it on your tax return. A major value of these contributions is reducing your taxable income for the current tax year.
When is tax-deferred money taxed?
The idea behind this approach is that American’s will save on taxes now when their earned income is higher. Then, when earned income is lower in retirement, the individual will be in the same or lower tax bracket. You see, every dollar you take from this account is taxed as ordinary income using the income tax brackets. Uncle Sam also charges you a 10% penalty when you withdraw money prior to age 59 ½.
Now we compare tax-free (Roth) accounts
Now, let’s discuss tax-free or Roth savings. Contributions are made from income that has already paid income tax. The money grows within the account tax-free. As long as it’s been 5 years since account opening and you are 59 ½, all of the money in this account can be withdrawn tax-free. That’s right, no tax on the growth. Otherwise, the growth is taxed as income and assessed a 10% penalty.
If you are contributing to a Roth 401(k), your employer will calculate your income tax prior to making the contribution. As for a Roth IRA, there is nothing to worry about on your taxes as there is no current income tax deduction.
Why choose a Roth account?
The idea for this strategy is that tax rates could be higher in retirement and paying taxes now saves on the higher rates. Additionally, may people like the idea of never having to pay taxes on the growth of this money.
There are annual contribution limits for these retirement accounts. Much more can be contributed to employer retirement plans than the individual traditional IRA and Roth IRA. The individual accounts also have limits based on earned income. The contribution limits for all retirement accounts continues to increase over time to account for inflation.
This was an overview to provide a high-level understanding of how tax-deferred and Roth savings work and differ. All of us have our unique situations, and there are additional rules to consider that I don’t have time to cover here. I encourage you to research which option or combination is best for you. A financial advisor is a great partner to have on this journey to help you make the best choice for your situation.
Thank you for joining me for Financial Freedom. I'm Josh Duncan, Financial Advisor with F5 Financial Planning, helping you achieve financial freedom for personal significance. Please contact me here to send topics you would like me to cover.
See you next time.
Photo credit: SCB TV (the producers of our video) on unsplash.com
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