Tax Deferred Accounts vs. Tax Free Accounts Which one is better?

Are you at a crossroads when it comes to deciding which retirement saving plans you should opt for? Well, while there is no straight-up answer as to which plan is the best overall, you can still choose which plan is best for you on the basis of your particular circumstances. 

The question of when tax becomes payable on your savings account is one of the most important considerations you should keep in mind. While you cannot get out of paying taxes with your retirement account, you do get a tax break sooner or later on contributing to one. When you want to avail yourself, this break is the factor that can tip you in favor of a tax free or tax deferred account. 

What are the main types of retirement savings plans?

IRAs and 401(k) s are the two main types of retirement savings plans that are available to people working in the USA. Deciding which one is best for you depend on a range of factors. 

These include what plans your employer offers, whether you are self-employed, what tax bracket you fall in now, what tax bracket you expect to fall in the future etc. 

There is no straightforward answer to whether you should opt for a tax deferred or tax free account since it is all relative and dependent on your individual situation. 

What is tax deferred accounts?

As the name suggests, tax deferred accounts are those on which the account holder does not need to pay taxes immediately. So if you make a contribution to this account, you do not need to pay any taxes on that contribution, and you can also deduct the amount of this contribution from the annual income tax you pay to the IRS. 

These accounts offer you tax relief upfront, and any savings you invest in this account grow in it till they are withdrawn. 

Traditional 401(k)

The most common retirement savings plan that working Americans have is the traditional 401(k). These are available only through employers, and your employer offers various investment options for you to choose from. You can contribute $19,500 on an annual basis to the traditional 401(k). The money goes directly from your employer to your savings account, and this contribution is tax deductible. 

This means that it won’t be part of your taxable income for the year. However, you cannot withdraw money from this account before 59.5 years, and at the age of 72, you must make certain withdrawals that are known as Required Minimum Distributions (RMDs). 

Many employers also offer the option of employer matching with traditional 401(k)s: for every dollar, you contribute to the plan, the employer may “match” you and contribute a dollar of 50 cents too up to a certain level. 

Traditional IRA

Unlike 401(k)s, IRAs are Individual Retirement accounts and are not offered by employers. Instead, they need to be opened through banks or brokers who offer such services. Be sure to check whether the organization is registered with the IRS for providing such services in the first place. The

When should you opt for a tax deferred account? 

There are two reasons why a tax deferred account is the best option for you. The first is when you need the tax savings. You get a tax break up front, meaning that you have to pay lesser income tax, and the money you save can be focused elsewhere. 

The second advantage of a tax deferred account is that your investment can grow tax free. Since the money in a tax deferred account is “pre-tax,” this means that you have a greater amount of income that can go into the savings account, and thus, there is greater money available for investment. 

Thirdly, if you are not going to move to a higher tax bracket with age, it is better to obtain the tax break now since there may be more pressing expenses you could use the money for. 

What are the drawbacks of a tax deferred account?

The biggest drawback of a tax deferred account is that you may end up having to pay a greater amount of tax on it once you start making withdrawals. After you reach the age of 59.5 years, you can make withdrawals from these accounts without incurring a penalty. 

However, these withdrawals are classified as the “income” for that year by the IRS, meaning you do have to pay income tax on it. Just think about it; all the money you have saved and all the income you have earned on it is subject to taxes. 

This could mean that the income tax you pay today may be much lesser than the income tax you will have to pay on withdrawals, showing that from a purely mathematical perspective, you are taxed more in a tax deferred account. 

What are tax free accounts?

It is important to realize that no account is “tax free”. You will have to pay taxes sooner or later since they are the government’s due, and you cannot get out of it! However, the Roth account options, named after Senator Roth, are a relatively recent form of retirement savings and have increased in popularity ever since they were introduced in 2006. 

These accounts do not offer tax savings upfront: the contributions you make to them are not tax deductible. However, once you pay your income taxes due for now, the money grows freely in the account. Once you start making withdrawals, you do not need to pay any taxes. This is extremely useful since if your account accumulates enough wealth for you to make major withdrawals from your account such that you start falling into a higher tax bracket, you can use the money on your retirement without the hassle of taxes and end up saving a lot when you are older by paying relatively less taxes now. 

Roth 401(k)

While not all employers offer the Roth 401(k), when they do, you should seriously consider opting for it. The contributions to it are taxed, meaning that the withdrawals on retirement are tax free. 

You can annually contribute $19500 to it, and if you are above 50, you can also contribute $6500 more to it as catching up contributions, allowing you to make up for payments you couldn’t make earlier. A Roth 401(k) also allows you to make penalty free withdrawals before the age of 59.5 as well if you have had to account for 5 years and are making it on account of a disability or the death of the owner of the account. 

Roth IRA

Roth IRAs are perhaps the most flexible retirement savings option out there. There are no requirements as to making mandatory withdrawals, and neither do you need to have a formal employer to begin this account, and you can qualify for it at any age as long as you “earn” an income. 

You can also continue to make contributions to the account as long as you are earning, making it less ageist. The annual contribution limit for it is $6000 (for individuals under 50 years of age), which could be on the lower side for some people. 

When should you opt for a tax-free account? 

The first instance when you should invest in a tax-free account is when you expect to earn a lot on your savings. This is because if your account grows a lot, you will be making large withdrawals from it. Since you already paid your taxes on your income, these withdrawals will not be subject to income tax, meaning you have to pay no taxes at all on retirement, making it virtually “tax free.” Secondly, our advice is that if you are on the younger side, the Roth option is for you. 

This is because it is still early days in your career, and you do not know how much your income may grow over the years. The Roth account can be useful for you if you do become better off. 

What are the drawbacks of a tax-free account? 

The first drawback of a Roth account is that not many employers offer it today as well since it is relatively recent. The second disadvantage of a Roth IRA, in particular, is that it is off-limits for some people. People who earn too much cannot contribute much to these accounts since the IRS does not allow it. 

Moreover, the contribution limit can be a disadvantage since it means that you cannot accumulate a lot of wealth for retirement with a Roth IRA only. The third problem with Roth accounts is that they do not offer you tax relief upfront. 

When you have to pay taxes on your entire salary for the year, even that part of your salary which you do not use and which goes straight to your savings, it can be a lot. This is where traditional accounts are better options since they give you immediate savings and allow you to live your present life more comfortably. 

Can I contribute to tax deferred and free accounts simultaneously? 

It is possible for an individual to divide their savings contributions across different accounts. You could have a traditional 401(k) and a Roth IRA simultaneously. Investing in two accounts will allow you to make use of the advantages of both accounts. 

However, a word of caution: if you have a 401(k) account, your employer will offer you employer matching if you contribute to a certain level. If you invest in an IRA as well, you may not be able to meet the threshold to qualify for the benefits of a 401(k), meaning you cannot make the most of it. 

In Summary

With all the information in front of you, it may be easier for you to come to a conclusion regarding which accounts are better for you: tax-deferred or tax-free. The bottom line is that if you wish to avail tax benefits in the future (something that you should seriously consider if the increase in income is a real prospect for you), tax-free accounts may be more ideal. 

However, if you wish to cash in on a tax break today, then the tax deferred options are for you since the money you save on taxes can be used for things like everyday expenses, student loans, etc. Whether you opt for the traditional or the Roth option, just remember not to go too risky with your investments. It is possible for you to lose money on any savings account if you are not too careful with it. 

Are you still confused between tax deferred and tax-free accounts? RVW Wealth is there to help you. At RVW Wealth, we are committed to working for your benefit with a view towards ensuring your long-term success. You can call us at 310-945-4000 for more information on tax-deferred and tax-free accounts and which plan is better suited for you.