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Retirement Savings: Tax-Deferred or Tax-Exempt?

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Retirement Savings: Tax-Deferred or Tax-Exempt?

Tax planning is an essential part of any personal budgeting or investment management decision. When you're thinking ahead to retirement, tax planning should be part of your decision-making from the beginning. Start by reviewing the two basic types of retirement accounts that allow people to minimize their tax bills: tax-deferred accounts (TDA) and tax-exempt accounts (TEA). Both accounts minimize the amount of lifetime tax expenses one will incur, thus providing incentives to start saving for retirement at an early age. (See our tutorial on registered retirement savings plans: RRSPs: Introduction.)

Distinction Between the Accounts

Tax-deferred accounts allow you to realize immediate tax deductions on the full amount of your contribution. However, future withdrawals from the account will be taxed. For example, if your taxable income this year is $50,000 and you contributed $3,000 to a TDA, you would pay tax on only $47,000. In 30 years, once you retire, if your taxable income is initially $40,000, but you decide to withdraw $4,000 from a TDA account, taxable income would be bumped up to $44,000. Essentially, as the name of the account implies, taxes on income are "deferred" to a later date. In Canada, the most common type of TDA is an RRSP, and in the U.S. it is the traditional IRA. (It may be better to leave your assets exposed to the tax man when you're saving to retire. Check out Not All Retirement Accounts Should Be Tax-Deferred.)

Tax-exempt accounts, on the other hand, provide future tax benefits because withdrawals at retirement are not subject to taxes. Since contributions into the account are made with after-tax dollars, there is no immediate tax advantage. The primary advantage of this type of structure is that investment returns realized within the TEA grow tax-free. If you contributed $1,000 into a TEA today and the funds were invested into a mutual fund which provided a yearly 3% return, in 30 years the account would be valued at $2,427. By contrast, in a regular taxable investment portfolio where one would pay capital gains taxes on $1,427, if this investment were made through a TEA, growth would not be not taxed. In Canada, the most common type of TEA is a tax-free savings account (TFSA), and in the United States, the Roth IRA is a popular TEA.

With a TDA, taxes are paid in the future. With a TEA, taxes are paid right now. However, by shifting the period when you pay taxes and realizing tax-free investment growth, major advantages can be realized.

“I like to describe a tax-deferred account as really being tax-delayed. Taxes will be paid someday down the road. A tax-exempt account however, is tax-free after the money is deposited into the account,” says Mack Courter, CFP®, founder of Courter Financial, LLC, in Bellefonte, Pa.

Account Benefits – Tax-Deferred

The immediate advantage of paying less tax in the current year provides a strong incentive for many individuals to fund their tax-deferred accounts. The general thinking is that the current tax benefit of current contributions outweighs the negative tax implications of future withdrawals. When individuals retire, they will likely generate less taxable income and therefore find themselves in a lower tax bracket. High earners are strongly encouraged to max out their TDA accounts to minimize their current tax burden.

Also, by receiving an immediate tax advantage, an investor can actually put more money into their account. Let's assume, for example, that you are paying a 33% tax rate on your income. If you contribute $2,000 to a tax-deferred account, you will receive a tax refund of $660 (0.33 x $2,000) and thus be able to invest more than the original $2,000 and have it compound at a faster rate. This is assuming you didn't owe any taxes at the end of the year, in which case the tax savings would simply reduce your taxes owed. (Increasing your savings will provide tax benefits – and peace of mind. See Maxing Out Your RRSP (Canadian).)

Account Benefits – Tax-Exempt

Because the benefits of TEAs are realized as far as 40 years into the future, some people ignore these accounts. However, young adults who are either in school or are just starting work are ideal candidates for tax-exempt accounts. At these early stages in life, one's taxable income and the corresponding tax bracket are usually minimal but will likely increase in the future. Although the TFSA allows missed contributions to roll over, meaning that if you did not contribute the maximum amount this year you will be able to add that amount to next year's allowed contribution, in future years you are likely to generate more income and find yourself in a higher tax bracket.

By opening a TEA today and investing this money into the market, an individual will be able to access these funds along with the additional capital growth without any tax concerns. Since withdrawals from this type of account are tax-free, taking money out in retirement will not push you up into a higher tax bracket.

“The conventional belief that taxes will be lower in retirement is outdated,” says Ali Hashemian, MBA, CFP®, president of Kinetic Financial in Los Angeles, Calif. “The modern retiree spends more money and generates more income than previous generations did. Also, the tax environment may be worse for retirees in the future than it is today. These are just some of the reasons that tax-exempt strategies may be advantageous.”

“I cannot think of anyone who does not benefit from tax-exempt,” says Wes Shannon, CFP®, founder of SJK Financial Planning, LLC, in Hurst, Texas. “Oftentimes, a client who is in a high tax bracket and has a long-term-growth–oriented investment strategy will be able to take advantage of capital gains and qualified dividend taxation (currently at lower rates), whereas tax-deferred converts all gains into ordinary income, which is taxed at the higher rate.”

Which Account Is Right for You?

While the ideal tax optimization strategy would involve maximizing contributions to both tax-deferred and tax-exempt accounts, there are certain variables to consider if such allocation is not possible.

Low-income earners are encouraged to focus on funding a TEA. First, at this stage, contributions to a TDA would not make much sense seeing as how the current tax benefit would be minimal but the future obligation would be large. Someone who contributes $1,000 into a tax-deferred account when they incur a 15% income tax would only save $150 today. If those funds are withdrawn in five years when the person is in a higher tax bracket and pays a 30% income tax, $300 will be paid out. On the other hand, contributions into a TEA are taxed today, but, assuming that you will be exposed to a higher tax bracket in proceeding years, your future tax bill will be minimized.

Higher salary earners should focus on contributions to a tax-deferred account such as an RRSP or traditional IRA. The immediate benefit can lower your marginal tax bracket, resulting in significant value. Your current and expected future tax brackets are the primary driving factors in determining which account is most suitable for your tax-planning needs.

Another crucial variable to consider is the purpose and time-frame for your savings. TDAs are usually, but not always, preferred as retirement vehicles since most people will have minimal earnings and may have a lower tax rate at this life stage. TEAs are often preferred for investment purposes, since an investor can realize significant tax-free capital gains.

“I actually think clients often load up too much on tax-deferred accounts,” says Marguerita Cheng, CFP®, CEO of Blue Ocean Global Wealth in Gaithersburg, Md. “Just as we preach investment diversification, tax diversification is just as important. It's important to realize tax savings today. However, there is something to be said for tax-free or tax-exempt retirement savings. The combination of dollar cost averaging, time value of money and tax-free growth is a powerful trifecta.”

Whatever your financial needs, a financial advisor would be able to suggest which type of account is best for you. (Consolidating retirement assets? Make sure you account for pre-tax and after-tax assets separately. Read How After-Tax Rollovers Affect Your IRA.)

The Bottom Line

Tax-deferred and tax-exempt accounts are among the most common available alternatives to facilitate financial freedom during retirement. When considering the two alternatives, just remember that you are always paying tax – depending on your type of account, it's only a question of when.

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