Tax-deferred vs. tax-exempt: retirement accounts & planning

Taxes are a major part of your retirement strategy, and tax-advantaged accounts are the go-to way to reduce what you owe. This includes tax-deferred and tax-exempt accounts. 

So, what’s the difference?

‍Tax-deferred accounts delay your tax bill until you access the cash. You contribute pre-tax cash to the account. Once you reach retirement and begin distributions, you’ll owe income taxes on the withdrawn funds.  

‍Tax-exempt accounts permit tax-free withdrawals. That doesn’t mean you don’t owe any taxes — instead, you pay regular income taxes before placing your money into the account. The balance and earnings grow from there, giving you the opportunity to withdraw your money tax-free in certain conditions.

How does this all play into your retirement strategy, and how do you know which account type is best for you? We’ll walk you through the pros, cons, and financial freedom strategies below. 

What are tax-deferred accounts?

“Defer” means to postpone, so tax-deferred accounts are literally accounts that postpone your taxes until a later time. 

While the government typically takes income taxes from your paycheck before it drops in your bank, tax-deferred account contributions come out even earlier.

With a tax-deferred account, the tax bill comes due  when you withdraw instead.

So, how does this benefit your taxes?

Some people’s income is higher now than it will be in retirement, which means their tax rate is higher now, too. We’ll walk through an example to break this down:

Now, consider that you’re investing in your retirement for 40 or 50 years, and you quickly realize how valuable tax-deferred accounts are. 

Many retirement accounts offer tax-deferred and tax-exempt options. This is the case for 401(k)s and IRAs. 

Traditional 401(k)s 

A 401(k) is a type of employer-provided, defined contribution retirement plan. You can enroll in an account through your employer or with a solo 401(k) if you’re self-employed. 

‍Most 401(k)s are traditional, tax-deferred accounts. Beyond the tax savings, account features include:

• High contribution limit: $23,000 in 2024
• Catch-up contributions for investors 50+ years old: $7,500 in 2024
• Employer-match potential
• Required minimum distributions (RMDs): Start at age 73 or when you quit working 
• 401(k) loan potential

Other types of tax-deferred accounts include: 

• SIMPLE 401(k): A 401(k) plan for small businesses with 100 employees or fewer that requires employer contributions. 
• Solo 401(k): A 401(k) plan available to single-member LLCs without full-time employees, as well as self-employed individuals and their spouses. 
• 403(b): An employed-provided, defined contribution plan for tax-exempt employers, like public schools and libraries. 
• 457(b): A deferred-compensation retirement plan provided by local and state governments.

All of these are tax-deferred accounts with the same $23,000 employee contribution limit, though employer contribution limits and permissions may vary. Limits for solo 401(k)s can also vary based on income. 

Traditional IRAs

Individual retirement accounts (IRAs) are independently owned instead of employer-provided, so anyone can open one. Like 401(k)s, you can choose a pre-tax traditional account or an after-tax Roth account. 

Here’s an overview of IRA features and benefits:

• Contribution limit: $7,000 in 2024
• Catch-up contributions for investors 50+ years old: $1,000 in 2024
• RMDs: Start at age 73 for traditional accounts only
• Wide range of investment options

Traditional IRAs share many of the same tax advantages as a 401(k), except your tax deduction isn’t guaranteed. If you or your spouse contribute to a 401(k), you might not qualify for IRA tax deductions based on your income:

If neither you nor your spouse have an employer-provided retirement plan, you’ll receive your full IRA tax deductions. Even if you don't qualify for deductions, you can maintain a nondeductible IRA.

There are other types of tax-deferred IRAs available, depending on your eligibility. Unlike regular IRAs, these permit employer contributions, and limits and regulations vary a bit. 

• SIMPLE IRA: a plan for small employers to provide retirement benefits and contribute to employee IRAs. 
• SEP IRA: a plan for all-sized businesses and self-employed individuals that only accepts employer contributions. 

What are tax-exempt accounts?

Tax-exempt accounts are exactly what they sound like: exempt from taxes. . 

Instead of reducing your taxable income today, you pay your regular income taxes on your income and contribute what you want to the account. Then, your earnings grow tax-free, allowing you to withdraw your money in retirement without owing the government taxes on the distributions. 

Tax-exempt accounts are often called “Roth” accounts, and they’re ideal if you expect you’ll earn a higher income in retirement than you do now. 

This way, you pay taxes on a smaller balance (contributions only, not earnings), and there’s a chance your taxes are charged at a lower rate since your total income is lower today than it would be in retirement. 

Let’s flip the example from earlier to demonstrate:

Tax-exempt accounts have several benefits for your finances, but it’s not all roses: 

Roth 401(k)s 

Roth 401(k)s are the traditional 401(k)’s tax-exempt brother. You fund the account with after-tax contributions up to $23,000 in 2024 (excluding catch-up contributions), then you access the cash tax-free when you retire. 

In this case, you’re reducing your future taxable income by paying taxes on contributions today — ideally at a lower rate than you would pay in retirement — and generating tax-free earnings with your investments. 

There’s another major advantage Roth accounts have over traditional — there’s no required minimum distributions (RMDs) until after death when they become your beneficiary’s problem. 

It’s also worth noting that some employers won’t offer employer-match contributions to Roth accounts. So if that’s you, we’d go with a traditional — otherwise, you’re leaving free money on the table. 

Roth IRAs

A Roth IRA is also a tax-exempt retirement account, but it isn’t tied to your employer. You can open a Roth IRA yourself and hand-select the investments you like, contributing up to $7,000 before catch-up contributions. 

Roth IRAs are a little more unique than Roth 401(k)s and traditional IRAs. Here are the major differences to know:

• Penalty-free withdrawals on contributions, any time, anywhere. However, you’ll owe a 10% penalty if you dip into your Roth IRA earnings before age 59 ½. 
• No RMDs until after death. 
• A five-year rule restricts penalty-free distributions until you’re at least 59½ years old and have owned the account for five years. 
• High-income investors might not qualify for direct contributions based on their income. Roth IRAs phase out at these income ranges:some text
  • Single filers and heads of household: $146,000-$161,000
  • Married couples filing jointly: $230,000-$240,000
  • Married filing separately with a workplace retirement plan: $0-$10,000

Both tax-deferred and tax-exempt accounts have their place, and many investors benefit from contributing to both account types. 

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How to choose between tax-deferred vs. tax-exempt

It’s not an all-or-nothing decision. You can have several tax-deferred accounts, a diverse portfolio or both, or put all of your contributions into a few Roth IRAs. 

It ultimately boils down to:

• Current income: How much can you afford to contribute? Are you just starting your career, or are you making the most you’ll likely ever make?
• Future income: Are you planning on living large in retirement or living your twilight years on a modest income?
• Retirement age goals: Do you want to retire early and need to max your contributions, or do you have decades to save with a moderate investment allocation?

A lot of people enjoy a mix of retirement account types and will adjust their tax-deferred vs. tax-exempt allocations as they age. If you start with one, you can always convert your assets and roll over into another tax-advantaged account. Just know that a Roth conversion comes with a tax bill on the untaxed rollover balance.

But you want to get it right the first time, so here are some other scenarios when you might want to prioritize one account type over the other.

Go Roth if you’re in a lower tax bracket now

You can’t predict the future, but you can estimate your career growth, and a tax-exempt Roth account is the way to go if you’re dedicated to increasing your salary. 

You pay taxes before you invest your Roth contributions, so your tax bill is determined by your current income. And your tax rate increases as your income does, so get the taxes out of the way now before you earn that next big raise. 

With this strategy, you don’t have to worry about taxes in retirement, and your earnings grow tax-free instead of tax-deferred. 

Opt for tax-deferred if you’re at your career peak

Alternatively, you may want to minimize taxes while you’re at the height of your career and earning the most you ever will. 

Once your current income surpasses your expected retirement income, adjust your strategy and prioritize tax-deferred accounts to shift your tax burden to the future.. Then, you don’t have to worry about the contribution and earning taxes until you start retirement distributions. 

Choose tax-exempt accounts to maximize your investments

Tax-advantaged accounts aren’t always about retirement alone. Tax-deferred accounts are likely your best option if you are investing for your retirement first and foremost. 

After all, there aren’t many circumstances where you’ll earn more once you quit working than while employed. 

But some investors are thinking about more than incubating their nest egg. Tax-exempt accounts are a great way to build your wealth since earnings grow tax-free. 

Try a Roth account if you’re investing to reduce taxes on your wealth. Roth IRAs might be particularly beneficial, since you can access the contributions tax- and penalty-free and reinvest your earnings to continue account growth. 

Reduce your risk with a diversified portfolio of both

Most investors fall somewhere in the gray area, where they’re still growing their careers and have a couple of decades until they retire, but they’re not starting from scratch, either. 

If this is you, a diversified portfolio is the surest way to grow wealth without overspending on taxes. Your priority will likely evolve over time, and you can adjust your contributions accordingly. But there’s no reason to go all in on one account over the other at this phase in your life. 

The Playbook take: Know when and how your taxes are due

Tax planning is an important way to support your retirement and build personal wealth without giving your hard-earned cash to the government. Different tax-advantaged accounts serve different purposes, and understanding the differences between tax-deferred and tax-exempt accounts can help you reach financial freedom. 

Need help balancing your investments for the most tax efficiency? See how Playbook’s customized financial roadmap and tax strategies can save more of your time and money.