Do you REALLY know the difference between tax-free and tax-deferred?
What’s the difference?
Often people need help deciding whether to save for retirement in a Traditional or Roth-type of account; another way to put that is do you want tax-free or tax-deferred? This question can come up when you are signing up for your retirement plan at work or when you are deciding to open your own Individual IRA.
The brick wall is that most people don’t understand the difference, so how can they make an informed decision? I am here to help!
Taxes and Savings
Cast your memory back to when your savings account at the bank earned something called “interest.” Yes, I know it was long ago. But, do you remember that at the end of the year, you would get a 1099 for interest earned? You would add that dollar amount to your income for the year and pay taxes on it.
The same process happens in your non-retirement and non-college investment accounts. Every year you get a 1099 from your investment company reporting dividends, interest, and capital gains earned in the account. That income is taxable to you in that year. These are called “taxable” accounts.
Retirement accounts give us a break from those pesky annual 1099s and tax payments. This is to encourage us to save for our old age by giving us tax incentives.
In a tax-deferred account (Traditional IRAs, Traditional 401(k)s), you get to shelter your annual contribution from income taxes and not pay yearly taxes on interest/dividends/capital gains. When you take the money out for retirement spending, you will owe income taxes on the withdrawals you make each year from the accounts.
In a tax-free account (Roth IRAs, Roth 401(k)s), you do NOT get a tax deduction for the amounts you add to the account each year. The account grows without annual taxes like the Traditional accounts above. The big difference here is on the withdrawals. When you take money out of Roth accounts in retirement, you will owe NO income taxes.
So, the difference in a nutshell is do you want a tax break now (Traditional) or tax break in retirement (Roth)? There is no right or wrong answer since we don’t know if your taxes are higher now or later. Sometimes the best solution is to diversify – use a little of both.