Tax–Efficient Investing: Understanding Tax–Free and Tax–Deferred Retirement Savings

Tax-Deferred Investment Accounts

Tax-deferred accounts have been a staple of retirement investing since the 1980s. The most prevalent tax-deferred retirement accounts are traditional individual retirement accounts (IRAs) and employer-sponsored retirement accounts such as traditional 401(k)s or traditional 403(b)s. 

Benefits of Tax-Deferred Accounts

The money you invest in a tax-deferred account is deducted from your taxable income the year you make the contribution. This is often referred to as contributing pretax dollars to the account. Instead of paying your current income tax rate on the amount you contribute, you pay taxes when you withdraw money from the account duringin retirement. In the meantime, your investments can grow tax-deferred, and you don’t have to worry about capital gains taxes when you sell or trade assets within the account. When you withdraw money from a tax-deferred account duringin retirement, you will pay income tax according to your current tax bracket, not the tax bracket you were in when you made the initial contribution.

Limitations and Drawbacks of Tax-Deferred Accounts

All tax-advantaged retirement accounts have maximum contribution limits set by the IRS each year. As of 2024, the maximum 401(k) employee yearly contribution limit for a person under fifty is $23,000, and the limit for those over fifty is $30,500. For IRAs, the maximum yearly contribution limit for a person under fifty is $7,000, and the limit for those over fifty is $8,000. Additionally, because they are designated as retirement accounts, there are penalties and tax implications for withdrawing the money before you are fifty-nine-and-a-half years old. 

Who Benefits Most from Tax-Deferred Savings

Tax-deferred savings can be a great choice for anyone looking to reduce their tax burden or invest for retirement in a tax-efficient manner. However, the immediate benefit tax-deferred accounts offer is especially attractive for high-income professionals at the peak of their earning years and older individuals who have less time to rely on compound interest to increase the value of their investments. These individuals may benefit more from lowering their taxable income and using that tax break to invest more than they otherwise could. 

Tax-Free Investment Accounts

Newer options of tax-free, or tax-exempt, investment accounts include Roth IRAs, Roth 401(k)s, and Roth 403(b). The Roth IRAs first emerged in 1998 and Roth 401(k)s and 403(b)s became available in 2006. 

Benefits of Tax-Free Accounts

The money you invest in a tax-deferred account is taxed at your normal income tax rate the year you make the contribution, also known as contributing post-tax dollars. Then the investments can be withdrawn in retirement without incurring any additional taxes. Like tax-deferred accounts, you do not incur capital gains taxes when you sell or trade assets within the account, and your investments can grow tax-free. 

Limitations and Drawbacks of Tax-Free Accounts

More employers are offering their employees Roth 401(k) and 403(b) options than in previous years, but employer-sponsored tax-free accounts are still less commonly available than their tax-deferred counterparts. When tax-free accounts are available, the same maximum contribution limits that relate to tax-deferred accounts still apply. Tax-free accounts do not give any immediate tax benefit in the year you make the contribution, so it takes longer to realize the tangible effects of the tax benefit. 

Who Benefits Most from Tax-Free Savings

Tax-free accounts are most beneficial for individuals who are currently in a lower tax bracket than they anticipate being in when they retire. Many people prefer to invest in Roth accounts early in their career when their salary is relatively low because they expect their income to increase significantly throughout their career. Investing in Roth accounts when you are young is particularly beneficial because your investments will have ample time to increase in value, enabling you to make the most of the tax-free withdrawals in retirement. A similar principle is applicable to people who intend to leave assets in their retirement accounts for their loved ones to inherit, thereby extending the time horizon and growth potential of the assets. It can also be wise to invest in a Roth account during certain seasons of life when your income is much lower than normal, such as during years when you take extended leave (e.g., sabbatical, parental leave, career changes).