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Tax-deferred investments delay your tax bill to prioritize compound growth, while tax-free investments mean no taxes are due at withdrawal.
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Tax efficiency is the real beauty of retirement accounts like 401(k)s and Roth IRAs. If you understand the differences between tax-deferred vs. tax-free investments, you can piece together a retirement strategy that maximizes your wealth and minimizes your tax liabilities.
So, what’s the difference? It’s simple — tax-deferred assets delay taxes until a later date, while tax-free assets aren’t taxed at all.
We’re making a slight distinction between tax-deferred vs. tax-exempt accounts. You don’t owe taxes on earnings from tax-exempt accounts (also often called tax-free accounts), but you still pay income taxes on earned money before contributing it to the account.
So, “tax-free” can be a little misleading. After all, it’s one of Benjamin Franklin’s life guarantees — you can’t totally avoid death and taxes.
To help you understand the distinction and bulk up your tax strategy, we’ll dig further into the differences below.
Tax-deferred means all owed taxes are delayed — typically until you withdraw the money. That means you contribute pre-tax funds from your paycheck, so your initial balance is larger and compounds faster.
This is great for retirement planning because long-term, steady growth is the name of the game. The earlier you contribute and the more funds you invest, the larger and faster your account balance grows.
Here’s a breakdown of the features of tax-deferred accounts:
Tax-deferred accounts include anything that accepts pre-tax contributions. These are typically “traditional” accounts, and many of the same account types offer traditional and Roth (tax-exempt) options.
Tax-deferred investments and accounts include:
Tax-free investments don’t get you out of cutting a check to Uncle Sam. Instead, you fund the account with income you already paid taxes on.
So, what’s the big deal with these accounts if you still have to pay taxes?
Your earnings grow tax-free, which means you don’t owe taxes again. That’s a huge perk if you’re trying to save over $1 million to live off interest alone, since most of your balance is compound returns.
It’s worth noting that you’ll likely contribute less to a tax-free account since you have to pay taxes first. You have less income to work with, so it’s natural to save less. But the tax savings can more than make up the difference in the long term.
Tax-free investments are exempt from taxes on withdrawals because you already paid taxes on your contributions before funding the account. Keep in mind, however, that while withdrawals of contributions are always tax free, withdrawals of earnings are only tax free after age 59.5.
Many tax-free accounts are “Roth” versions of tax-deferred accounts, like Roth 401(k)s and Roth IRAs.
There are several other types of tax-free investments, including:
Good news — you don’t have to choose. Many investors benefit from maintaining both types of accounts to protect against risk and balance tax advantages.
But there’s a good chance one option is a little better for your personal circumstances, and it’s important to know which that is. Consider these factors to determine which tax-efficient investments to prioritize, and consider chatting with a professional for additional guidance.
Both tax-deferred and tax-free investments benefit retirement saving and general wealth building, but they also have their specialties.
If your number one concern is retirement, tax-deferred accounts are your best bet.
There are few situations where your income and tax bracket will be higher while unemployed in retirement than they are now while actively working and investing.
So, deferring your taxes until your tax rate drops is an easy choice to make.
Investors wanting to grow their personal wealth first might like tax-free investments.
Because you already paid your income taxes and don’t owe anything on returns, you don’t have to worry about a huge tax bill if your investments win big. Whether you make a $5,000 or $50,000 return, your taxes aren’t affected, and you get to keep everything for yourself.
However, there are still rules about when you can withdraw earnings, so it’s not like you can cash out tax-free before retiring. At least not without some penalties.
Some people find a cozy job and stick within that income range for decades, while others are always looking for the next move to boost their salary and reputation.
Both are perfectly valid ways to live your life, but your personal choice impacts your investment priorities.
If you love your job and plan to stick around with just an annual raise, or you’re wrapping up your career and at peak earning power, choose a tax-deferred account.
You’ll pay less taxes later when you retire, assuming your income drops, than now when your salary has you in a higher tax bracket.
Career climbers have a ways to go until they reach their full salary potential, and a mix of tax-free and tax-deferred accounts is likely the way to go.
Your retirement income will still likely be lower than it is today, so deferred taxes are great. But your retirement contributions will increase with your salary, so there’s a chance your future retirement income ends up higher than you expect.
In this case, tax-free investments get the bill out of the way so you don’t have to worry about splitting your retirement income with the government.
If you have children, dependents, or otherwise just want to leave some wealth behind for your loved ones, you also have to consider how your investment choices impact your estate.
Tax-deferred plans like 401(k)s enforce required minimum distributions (RMDs) beginning at age 73. This eats into your account balance and reduces the wealth you leave behind.
Tax-free Roth accounts don’t enforce RMDs until the account holder’s death, so you can leave your full investment to your heirs. This way, they receive all account distributions, and your investments can continue to grow tax-free while you’re alive.
Diversified investments are almost always the right choice. Whether you’re looking at asset allocations or tax advantages, you probably don’t want to place all of your eggs in one basket.
There are outliers, but a mix of tax-free and tax-deferred investments generally helps reduce your overall tax liabilities while preserving some flexibility to navigate your finances and market performance.
You can’t predict what tax rates will be in 10, 20, or 40 years. So, contributing to both investment types is a way to hedge against a heavy tax bill if rates increase drastically.
You also have more freedom with your retirement income.
If you only invested in tax-deferred accounts, you would owe taxes on your entire retirement income each year. If you mix tax-efficient accounts, you can strategize distributions to tailor your tax bill to your specific situation each year.
Taxable, tax-deferred, and tax-free all have different tax implications — understanding how your investments and their taxes stack up is vital. Otherwise, you could overburden yourself with a huge tax bill or reduce your wealth with inefficient investing.
All tax treatments have their place, but you’ll want to prioritize different advantages based on your circumstances and goals. Need help seeing the road to financial freedom?
Playbook can help with a personalized financial plan, tax strategies and more.