When it comes to saving for retirement, there are two ways to fund the account(s). You either use pre-tax (traditional plans) or after-tax (Roth plans) funds. This is true for both 401(k) plans and IRAs. So, what’s the difference between tax-deferred vs. tax-free retirement funds?
When you invest in a traditional retirement plan, you are using pre-tax money. Essentially, your contributions are withdrawn before they are taxed. For example, if you have a workplace 401(k) plan, your contributions are taken out before you receive your paycheck. Let’s say your gross income is $1,000 per week and you want to contribute $100 to your traditional 401(k). That $100 is sent to your 401(k) first (leaving you with $900 of taxable income). Now, that $900 is taxed based on your tax bracket and you then receive your paycheck, minus taxes and your 401(k) contribution. You receive an immediate tax break and the taxes are deferred until you withdraw from your 401(k).
Obviously, the main advantage of tax-deferred accounts is the ability to lower your tax bill in a given year. Since your tax bracket is based on your earned income for the year, any traditional contributions that lessen your income will be taken from the highest bracket. To simplify, let’s say your annual salary is $90,000. That puts you in the 32% tax bracket in 2019. Since the cutoff for the 24% tax bracket is $84,200, $5,800 of your income will be taxed at the 32% rate. However, if you were to contribute that $5,800 into a tax-deferred account, you will fall back into the 24% bracket entirely.
The other significant advantage is the ability to pay taxes at a lower rate during retirement. This is especially true if you are at your peak earnings potential, in which you’ll see your highest tax rates. With a tax-deferred account, you can hold off on paying those higher rates and wait until you start take distributions during retirement, when your tax hit will be significantly less. Note: you must wait until you reach age 59 1/2 to withdraw from your retirement plan to avoid the early withdrawal penalty.
Listen to IRA Financial’s Adam Bergman talk about the differences between traditional and Roth IRAs in a recent podcast.
Who doesn’t like the words “tax-free”? When it comes to retirement accounts, tax-free refers to your withdrawals. As we stated earlier, you need to fund a Roth plan to reap the tax-free rewards. A Roth IRA or Roth 401(k) plan is funded with after-tax money. As opposed to a traditional plan, you don’t get an immediate tax break. Using our example from above, if you earn $1,000 per week, the entire amount will be taxed. The Roth plan will be funded after the taxes are calculated. However, your retirement account will grow tax-free and you will never pay taxes on distributions from a Roth plan (so long as you follow the rules).
Tax-free distributions is the number one advantage of Roth plans. Not only are your contributions tax-free, but also any earnings from your investments. For example, if you contribute $50,000 to a Roth IRA throughout your working years and it grows to $1,000,000, the entire million will be tax-free, not just the $50k in contributions! Taxes must be paid on the entire balance of a traditional plan that are withdrawn.
While traditional plans offer you an immediate tax break, you might not need it when you first start working. Often, when you enter the workforce, you will be in a lower tax bracket. The tax break is not as important for you if this is the case. Rather, you can pay taxes now at a lower rate and then enjoy the tax-free benefits later in life. Generally speaking, a Roth plan offers greater benefits over the long run.
One last thing to consider is that you can contribute to a Roth no matter your age. As long as you have earned income for the year, you can contribute to a Roth. On the other hand, traditional plans cannot be funded once you reach age 70 1/2. The exception to this rule is if you’re still working, you may contribute to that plan (as long as you don’t own at least 5% of the business).
Tax-deferred vs. Tax-free: Which Should You Choose?
Everyone’s situation and retirement goals are different, so there’s no one right answer to this question. However, there are a few things you should consider:
- If you are younger and have not reached your earnings potential, a Roth plan is typically the better choice. On the other hand, if you’re currently in a high tax bracket, the tax break of the traditional plan might be better.
- Required Minimum Distributions – You are required to take mandatory distributions from traditional IRAs and 401(k) plans once you reach age 70 1/2. If you plan on utilizing your retirement funds throughout your golden years, this is perfectly acceptable. However, if you are in a comfortable financial situation and don’t really need those funds and wish to leave them to a beneficiary (such as your child), a Roth is much better. Roth plans are a great estate planning tool since you are never required to withdraw from the account. Your account will continue to grow unhindered until your passing.
- Since Roth plans are funded with after-tax money, you are allowed to withdraw contributions at any time, penalty-free. This can come in handy if you are in dire straights for some cash. You will be penalized most of the time when you withdraw funds from a traditional account before the age of 59 1/2.
- One last thing to consider is your adjusted gross income (AGI). If you earn too much money, you cannot contribute to a Roth IRA. For 2019, that number is $137,000 if you’re single and $203,000 if you are married. Roth 401(k) plans do not have this restriction. However, you are allowed to rollover traditional funds to a Roth IRA, but you must pay taxes on that amount.
Whichever route you plan on taking, it’s imperative that you save for retirement. The earlier you start and the more you contribute, the better you will be in the long run. There really is no right or wrong answer when choosing between tax-deferred vs. tax-free savings. Saving is the real key here.