Tax-Free or Tax-Deferred? How to Pick the Right Plan
Estimated reading time: 3 minutes
Choosing a retirement plan can be daunting. One of the key choices you’ll need to make is between tax-free and tax-deferred plans.
Tax-deferred Plans
Tax-deferred plans are made of pretax income. Types of tax-deferred accounts include Traditional, SEP, and SIMPLE IRAs. The funds in these accounts grow tax-deferred.
Tax-deferred Advantages
Choosing a tax-deferred account can benefit you in several ways.
- You don’t need to pay taxes until you take a distribution.
- Your contributions may qualify for a tax deduction.
- There are no income limits.
- SEP IRAs provide employers with a simple way to contribute to their own and their employees’ retirement.
Who Tax Deferral Is Good For
Tax-deferral is a particularly good choice for people who earn a sizable income that exceeds the Roth IRA income limits (although a Roth conversion maybe a solution to this limitation), or those who need the upfront tax break.
If you are self-employed or the employer of a small business, a SEP IRA might be exactly what you’re looking for. The SIMPLE plan serves a similar purpose to the SEP, but is limited to businesses with 100 or fewer employees.
Tax-free Plans
A tax-free plan, more commonly referred to as a Roth account, is made of post-tax contributions. The funds in the account grow tax-free. However, contributions to the account are not tax deductible.
Advantages of Tax-free Plans
Roth IRAs have numerous, distinct benefits.
- There are no required minimum distributions.
- Your distributions will be tax-free once certain requirements have been met.
- You pay the taxes on the money you contribute to your Roth upfront, so there’s no penalty if you withdraw your contributions.
- Multiple penalty exemptions allow you to withdraw earnings as well as contributions.
Who Tax-free Plans Are Good For
If it’s your intention to leave behind tax-free wealth to your beneficiaries, a Roth IRA has you covered. A tax-free plan can also be a good choice for people who expect their retirement tax bracket to be higher than or equal to their current one. Paying your taxes upfront will allow you to take advantage of being taxed at a lower rate and save you money in the long run.
A tax-free strategy can also help you avoid impacting other retirement benefits (i.e., social security) by lowering your taxable income.
Lastly, Roth IRAs are beneficial to those whose income falls within the Roth limits. You won’t be able to establish a Roth IRA right away if you earn income over a certain threshold, but you might be able to open a Traditional IRA and initiate a Roth conversion later.
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How to Choose
Some of the perceived advantages and disadvantages of the accounts lie in how much income you’re earning now, versus how much you think you’ll receive when you retire.
You might want to consider how your income tax bracket could rise over time. Young investors who are just starting out their careers might expect larger increases in their compensation over time, as opposed to older investors nearing retirement age.
You may also want to consider the amount you plan on contributing. IRA contribution limits vary based on your age.
Ultimately, the two things that are considered inevitable in life are death and taxes—so the question is, do you want to be taxed now (see tax-free), or later (tax-deferred)?
Give us a call if you want to chat about it.
You might also want to check out our webinar, Tax-Free or Tax-Deferred: How to Pick the Right Account For You.
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