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Tax-deferred vs. tax-free investments + how they fit your retirement

Tax-deferred investments delay your tax bill to prioritize compound growth, while tax-free investments mean no taxes are due at withdrawal.



May 21, 2024

6 min. read

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Key Takeaways:
  • Tax-deferred investments in 401(k)s, IRAs, and other retirement plans mean you don’t owe taxes until withdrawal. 
  • Tax-free investment earnings within Roth accounts, HSAs, and tax-exempt funds aren’t subject to taxes at all since you paid income taxes before making a contribution. 
  • Tax-deferred accounts are typically best for long-term retirement investments, while tax-free accounts can grow your wealth more efficiently. Most investors benefit from both. 

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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. 

      What’s tax-deferred?

      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:

      • Larger contributions for growth — especially if you start investing early.
      • Potential for reduced taxable income today. High earners with an employer-provided plan (like 401(k)s) may not qualify for deductions based on their income. 
      • Potential employer-match contributions with eligible tax-deferred plans.
      Pros: Cons:
      Pre-tax contributions may be tax-deductible. Pay taxes on contributions and earnings at withdrawal.
      Pay less taxes if you’re in a lower tax bracket at retirement. RMDs begin at age 73 or when you quit working, depending on the account.
      Reinvest tax deductions for rapid, compound growth.

      Tax-deferred account examples

      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:

      • Employer-provided retirement plans including 401(k)s, 403(b), and profit-sharing plans. 
      • Traditional IRAs, SEP-IRAs, and SIMPLE IRAs.
      • Tax-deferred annuity (TDA) retirement plans.
      • Municipal bonds. 
      Image breaks down the befits of deferred taxes for retirement planning + deductions based on account.

      What’s tax-free? 

      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. 

      Tax-deferred vs. tax-free example:

      We’ll keep it simple and say you open two accounts and contribute $1,000 pre-tax to one account, and another $1,000 after-tax to the second. Contributions continue for 20 years and earn 10% annual returns. Your balance reaches $63,773.40 in each account, and then you cash it all out.

      At that point, your tax bill comes due.

      Assuming you earn $75,000 a year and withdraw the full balance, your federal tax-deferred bill is $33,998 with earnings and contributions.

      With the same salary, your tax-free bill is just $14,499 each year, including your income and after-tax contributions.

      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.

      Pros: Cons:
      Potential to decrease taxes if you expect your tax rate to increase by retirement. Contributions aren’t tax-deductible.
      Tax-free growth allows you to build wealth without increasing your tax bill. Employer match perks might not apply, depending on your plan.
      Delayed RMDs until after death are best for estate planning.

      Tax-free account examples

      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:

      • Municipal bonds.
      • Tax-exempt mutual funds. 
      • Health savings accounts (HSAs) for medical expenses.
      • Education Savings Accounts (ESAs) and 529 plans for education costs.
      Image explains how tax-free investments boost retirement, wealth, estate, and education investments.

      How to choose tax-deferred vs. tax-free 

      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. 

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      What’s your primary goal — retirement or wealth?

      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. 

      Tax tip:

      In most cases, we recommend starting with a good old 401(k). These have higher contribution limits and employer-match potential, so you can really drive growth with large contributions. Plus, you’ll enjoy some tax savings today.

      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.

      Graph and image compare taxxable, tax-deferred, and tax-free growth.

      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.

      Tax tip:

      If you’re looking for long-term growth, we like Roth IRAs. They’re technically a retirement account, but you can tap into your contributions anytime without triggering a penalty or tax event. Meanwhile, you reinvest your earnings to keep the account growing.

      Where do you fall in your lifetime earning potential?

      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. 

      Are your investments part of your estate? Go tax-free

      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. 

      Want the best of both worlds? Diversify your accounts

      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.

      The Playbook take: Protect your wealth with both investments

      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. 

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      About the author

      Phil Wettersten, Series 7 & 66

      Head of Product Success

      Phil holds both Series 66 and Series 7 credentials and previously served as an Investment Consultant at TD Ameritrade. At Playbook, he's the authoritative voice representing our customers, spearheading product enhancements and strategic planning. Phil's unwavering dedication keeps us ahead in delivering top-notch user experiences.

      Tanza Loudenback, CFP®


      Tanza is a CFP® certificant, writer, and editor. From 2015 to 2021, she was a top-read author and editor at Insider. Her work focuses on helping people make smart decisions with their money and is published by a variety of online publications.

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      Save your cents from Uncle Sam

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      Save your cents from Uncle Sam

      Grow your wealth with a personalized financial plan and tax-advantaged investments.

      Start saving today

      Save your cents from Uncle Sam

      Grow your wealth with a personalized financial plan and tax-advantaged investments.

      Start saving today

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