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Tax-Deferred vs Tax Free: What's the Difference?

If you don’t mind paying a tax on your retirement withdrawals, tax-deferred accounts may be the best account for your future.
Tax-Deferred vs Tax Free: What's the Difference?

Tax Deferred vs Tax Free: What’s the Difference?

Tax Deferred vs Tax Free

Choosing the right investment for your retirement plan takes a great deal of research. Aside from selecting assets and the right company, considering how you want your funds to grow takes some careful thought.

Are you interested in having your retirement fund grow tax-deferred with a traditional IRA, or are you intrigued by the tax-free investing of a Roth IRA? Before deciding on the right plan for you, here are some differences between tax-deferred and tax-free accounts and how they can affect your account growth.

Tax-Deferred Investing

The most common tax-deferred investment comes in the form of the traditional IRA. Whether you have selected a traditional IRA through a trust to invest in stocks, bonds, and treasury, or a self-directed IRA with alternative assets, both plans have one thing in common: tax-deferred growth.

This investment allows account holders to have immediate tax deductions on the full amount of their contribution.

The taxes are then “deferred,” not deducted. When you invest in a tax-deferred option like a traditional IRA, it’s assumed that you deducted the contribution from your income.

From there, this money grows until you withdraw it from your account. All withdrawals made after you reach retirement age are considered taxable income. Your contributions are considered 100% taxable, since the funds were taxed previously.

Tax-Deferred vs Tax Free: What's the Difference?

Benefits of Tax-Deferred Accounts

If you are considering a tax-deferred account, one of the primary benefits is that you will be paying fewer taxes as you make contributions. Contributions you make into your retirement savings will benefit from the full contribution, only being taxed on withdrawal.

These extra funds will give your fund a substantial boost over the long-term life of your account. Another added tax advantage as you reach retirement age it that you’re more likely to be in a lower tax bracket. This is taken under consideration as you take distributions.

With the tax-deferred option, it’s important to weigh your options; would it be more beneficial for you to accept the tax break as you make your contributions or during retirement? While it is possible to be in a lower tax bracket when you reach retirement age, you still need to pay taxes on every account withdrawal. If you want to avoid any potential account hits, perhaps tax-free is a better option for you.

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Tax-Free Investing

Often an overlooked option, Roth IRAs and other tax-free accounts can be give account holders future tax benefits. While there are no up-front tax breaks, these investments are tax-free on withdrawal. Ideally, by making account contributions, you can freely take your funds without worrying about being hit by the fees.

Your account growth is not taxed so long as it is not withdrawn before the age of 59 ½ and the account has been open for at least five years. Your account will grow rapidly as you make your yearly contributions without the worry of taxation in your golden years.

Benefits of Tax-Free Accounts

The tax-free account is the ideal choice for anyone who wishes to start saving early on. If you are just starting your retirement, or have a low income bracket, you will benefit from your contributions. As place money into your account, there’s no need to contribute the full amount; you are able to add to your fund the following year.

Account holders can generate higher income over time, all while their previous contributions grow tax-free. As your career grows, it’s possible to be pushed into a higher tax bracket, which could further benefit your long-term account income.

The tax-free option is a great choice for anyone looking to start saving for retirement, regardless of income. As tax-free investors build their account, they can do so without the worry of being taxed after they reach retirement age. Unfortunately, the downfall with this investment choice is the lack of an immediate tax break. However, depending on your situation, a tax-free account can prove to be the perfect option for your nest egg, especially if you are looking to start investing early.

Selecting the Right Account for You

Depending on your situation, either account growth option can be the right choice. If you are looking for an account that will grow more quickly overtime, and don’t mind paying a tax on your retirement withdrawals, tax-deferred accounts may be the best account for your future.

If you want to avoid paying the tax on your withdrawals, a tax-free Roth IRA may be what you are looking for in a retirement plan. Consider where you are starting your journey into retirement, and select the investment that aligns best with your goals.

As always, when financial planning, perform your due diligence and consult a financial advisor as you prepare for your future. Your golden years await; what is your investment plan? Contact Horizon Trust today!

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