Tax-free vs. Tax-deferred Tax Planning

Planning for retirement is vital to ensuring your financial health in the future. But with the many tax-free and tax-deferred options out there, it can be challenging to know which investments are right for you. This guide covers what you need to know about tax-free versus tax-deferred tax planning so you can make the best decision for your financial future.

Key takeaways:

• Tax-deferred investment accounts allow you to make deductions on income taxes as you invest in a retirement account, such as a 401(k), an individual retirement account, or a pension.
• Tax-free accounts enable you to avoid being taxed on the income you withdraw when you start using the funds in your account, though you’ll still pay income taxes on contributions you make to the account before retirement.
• Tax-deferred and tax-deductible accounts are especially beneficial because you can defer income taxes until you start withdrawing retirement funds.
• Forming a strategy to diversify your contributions between tax-free and tax-deferred accounts can help you maximize your savings and reduce the amount you’ll owe in taxes.

Tax-Free vs. Tax-Deferred Investment Accounts

While tax-free can imply avoiding taxes altogether, these investment plans aren’t actually free from taxes. Essentially, tax-free investments account for post-tax contributions. This means that you won’t be subject to immediate income tax or taxes for any investment returns made during the year of filing, and the funds in your account accumulate tax-free. The only caveat is that your contributions to a tax-free account aren’t tax-deductible, so any money you contribute to a tax-free account will be subject to yearly income taxes.

Unlike tax-free plans, tax-deferred investment accounts allow you to defer — or put off — paying taxes on investment earnings and your income until a future date. This means that the money you contribute to a tax-deferred retirement account during the year isn’t subject to income taxes for that period. In addition, you won’t pay taxes on any returns your investments earn while the funds stay in your account. In essence, tax-deferred retirement plans account for pre-tax income.

Types of Tax-Free Investment Options

Here are several common tax-free investment options:

• Roth IRAs: Roth IRAs let you contribute post-tax money to your retirement account, but you can’t deduct these contributions. Instead, the tax-free benefit comes when you start withdrawing from your Roth IRA after retirement.
• Roth 401(k)s: Roth 401(k)s may sometimes be available through employers, but you can also enroll in a solo Roth 401(k) if you’re self-employed. You invest with post-tax funds, and withdrawals are tax-free in retirement.
• Municipal bonds: Municipal bonds are issued through local governments and fund various initiatives, such as community and infrastructure planning. You’re essentially loaning money to the government with a municipal bond, for which you receive a guaranteed return rate in interest and avoid federal taxes.
• Tax-exempt mutual funds: Some mutual funds have a tax-exempt status, meaning that you don’t pay taxes on the returns you earn from these funds. Since tax-exempt mutual funds typically hold municipal bonds and government securities, they can offer tax benefits and the ability to simplify your diversification across various government securities.
• Tax-exempt exchange-traded funds: Much like mutual funds, tax-exempt ETFs may also consist of municipal bonds, giving you the same tax-exempt status on investment earnings. There are several types of tax-exempt ETFs, including short-, mid-, and long-term options.
• Indexed universal life insurance: Usually, life insurance policies are tax-free investments when they transfer to the beneficiary. So if you have a permanent policy that earns a cash value, such as an IUL, this value can accumulate interest over time and remain tax-free.

Types of Tax-Deferred Investment Options

Below are several common types of tax-deferred investment options:

• 401(k) retirement plan: The 401(k) is the most common type of tax-deferred retirement plan that employers offer. By making regular contributions pre-tax, you won’t have to pay taxes on income or earnings until you withdraw during retirement.
• 403(b) retirement plan: These retirement plans are typically available for non-profit workers and can be invested in mutual funds and annuities, which can reduce the amount of taxes you owe when you withdraw during retirement.
• Traditional IRAs: Traditional IRA accounts also allow you to make contributions tax-free with your pre-tax income. However, you’ll pay taxes on gains and income when you make withdrawals in retirement.
• Tax-deferred annuities: Tax-deferred annuities are a type of deferred annuity that lets you supplement a base retirement plan, such as a 401(k) or IRA. Contributions to this type of annuity are typically pre-tax, which helps reduce your immediate taxable income.
• Deferred sales trusts: Deferred sales trusts involve a contract between investors and third-party trusts where real estate is sold in exchange for future installment payments. With these types of sales trusts, you can defer capital gains you earn on real estate investments over time.

Advantages of Tax-Free Investments

Tax-free investment accounts have several advantages. For one, there aren’t any minimum required distributions, so you can deposit funds according to your financial goals. Once you meet certain requirements, your distributions will also be tax-free. Because you’re paying taxes upfront when you contribute to your account, there’s no penalty to withdraw your contributions. Furthermore, tax-free accounts come with multiple penalty exemptions, allowing you to withdraw your contributions, as well as accumulated investment earnings, depending on the type of account.

For instance, tax-free plans, such as a Roth IRA, aren’t taxable as long as you’ve had the account for at least five years. Because the money you contribute to your Roth IRA is subject to immediate income tax, you won’t owe any additional taxes on funds you withdraw. Tax-free accounts can also help lower your taxable income, avoiding any effect on other retirement benefits you receive. Another advantage of tax-free plans is that you can pay taxes upfront on contributions you make at a lower rate, ultimately saving money long-term.

Benefits of Tax-Deferred Investments

Tax-deferred investment instruments offer many benefits, including the ability to put off paying taxes until you take distributions from your account. In addition, the contributions you make each year may qualify for tax deductions, giving you more ways to save money immediately and when you start withdrawing from your retirement account. Unlike tax-free options, tax-deferred investment plans don’t have any income limits, so you won’t need to worry about falling into a different income bracket that could otherwise affect how much you pay in taxes when you withdraw.

Depending on the type of tax-deferred account, you can opt to have your contributions withheld from your paycheck before taxes or deduct them when you file income taxes. Since contributions are pre-tax, they can reduce your taxable income. This means lower tax liability for the year you’re filing in. For example, a tax-deferred annuity allows you to accumulate earnings and interest pre-tax, reducing your taxable income for the year you file.

Strategic Considerations for Tax Planning

While both tax-deferred and tax-free options have advantages, it’s important to understand how these two approaches to tax planning can affect your future savings. Depending on your income bracket, a mix of tax-deferred and tax-free investments can be an efficient approach to allocating retirement funds and maximizing savings — both pre- and post-tax. Here are several considerations when it comes to tax planning and maximizing savings:

• Create a diverse portfolio of taxable and tax-exempt accounts. For example, if you have a 401(k) through your employer, you may opt for a tax-deferred annuity to supplement your savings and reduce the taxes you’ll owe when you withdraw in retirement.
• Protect against the unknown. With a diverse mix of taxable and tax-exempt accounts, you can better protect against any uncertainty regarding your tax bracket once in retirement. For instance, you may be able to minimize your overall tax liability by taking tax-free municipal bond earnings and long-term capital gains from taxable accounts and tax-free income from a Roth IRA.
• Consider charitable giving and estate planning. Maximize short- and long-term savings with charitable giving and estate planning. For instance, you could give appreciated securities from a taxable account to a non-profit organization and deduct this contribution to avoid capital gains tax later.

Potential Pitfalls and Misunderstandings With Tax-Free vs. Tax-Deferred Accounts

Contrary to popular belief, tax-deferred doesn’t always mean you’ll save on taxes. Similarly, being tax-free doesn’t mean being free from taxes altogether. A common misconception about tax-deferred investment accounts is that they allow you to defer taxes to a later date. While this is, in essence, what many instruments let you do, you can defer too much and end up with hefty taxes when you withdraw income from your account during retirement.

In addition, you can be subject to a penalty for early withdrawal from your retirement accounts, so it’s important to understand which assets are best allocated to tax-deferred and tax-free options. Contact the team at Anderson Advisors for more insights into the right investment and retirement planning options for you.