Tax-free vs Tax-Deferred
With so many investment options available, choosing the right plan can be difficult. As you consider your current financial situation and form your savings plan, take a look at how you want your investments to grow. With tax-advantaged investments, there are two possible options: tax-free and tax-deferred. Before you design your retirement plan, let’s explore what both options can do for your future.
What is Tax-Deferred?
If you want your entire contribution to accumulate wealth over time, then tax-deferred saving may be for you. By opening a traditional IRA, you can make contributions without having to pay taxes up-front. Your money will grow, tax-deferred, in your IRA. That means the full amount of your contribution will have capital gains for the life of your IRA. Additionally, you also receive a tax break from the contributions you make per year.
However, you will have to eventually pay the taxes on it. When you reach retirement age, you will have to pay taxes on the withdrawals. However, this plan may benefit you more in the long term, especially if you are in a lower tax bracket following retirement.
What is Tax-Free?
While traditional IRAs offer tax-deferred growth, Roth IRAs or Roth 401(k)s function differently. Your contributions are taxed up-front. All tax-free accounts are taxed before the contribution enters the fund. Your contributions will still accumulate over time, however; the benefit of a Roth account comes when you reach retirement age.
Once you reach 59 ½, any retirement withdrawals will be tax-free. No matter how much wealth your contributions have accumulated, you will still not need to pay taxes on withdrawals after retirement.
What’s the Difference?
The biggest differences, aside from how these accounts grow, is how they are set up and their growth. Traditional IRAs offer tax-deferred growth after the contribution is made.
These contributions are tax deductible. You get a tax break, and your contribution grows at full capacity until they must be withdrawn.
When you reach retirement, the likelihood is that you will be in a lower tax bracket, and your taxes will be lower. You can withdraw your funds at 59 ½. While these are good, you will be forced to take contributions at 70 ½. These are called required minimum distributions and not taking them can result in some financial penalties. All traditional IRAs are subject to RMD – so keep that in mind when making your selection.
Roth IRAs, in comparison, accumulate their funds after taxation. Contributions are made with after-tax dollars and once they are placed into the Roth IRA, they will accumulate capital gains. As you reach retirement age, you won’t have to pay taxes on the withdrawals.
Additionally, these accounts will continue to grow – and there are no required minimum distributions. They will continue to grow and can be passed onto future generations. However, if you make over a certain amount, you may not be eligible for a Roth IRA.
Tax-Free vs Tax-deferred: Which Should I Choose?
Before making your selection consider what you are looking to get out of your retirement fund. Each tax-advantaged IRA has its perks. Your decision can also be shaped depending on your financial situation and how you want your money to grow.
Traditional IRAs can benefit those with more money to set aside. They can receive tax-breaks on their contributions and let their money grow, tax-deferred. This works well, especially if you will be in lower tax bracket come retirement.
On the other hand, if you have less money to start, the Roth is an excellent choice. Your taxes are paid up-front, so you don’t have to worry about paying anything on them later.
Your withdrawals are made tax-free. Since your taxes were paid upfront, any withdrawals on Roth IRAs are not considered taxable income. Additionally, there are no required minimum distributions, so your account can continue to grow, tax-free. Regardless, either choice, your account will experience long-term growth for a comfortable retirement.
Performing Due Diligence
When it comes to saving for retirement, there are many paths you can take. It’s important to perform your due diligence to find the one that is right for you and your future. Using a tax-deferred or tax-free investment will help you reach your financial goals as long as you plan accordingly. Take your time, and with careful financial planning, you can achieve your long-term goals. As always, before making any retirement place decisions, consult a Horizon Trust financial consultant to see which plan is most beneficial for your future. Explore your options and start saving for retirement today!