The most common form of retirement account is tax-deferred. This refers to portfolios which allow untaxed contributions and gains during your working life, but which require you to pay income taxes on any money you withdraw in retirement. Other portfolios are known as tax exempt. But this is inaccurate, as the IRS does not offer any completely untaxed retirement accounts. These are post-tax portfolios that do not offer tax advantages on your contributions. However, you can withdraw the portfolio’s returns and principal tax-free in retirement. Here’s what you need to know.
A financial advisor can help you optimize your financial plan to lower your tax liability.
What Are Tax-Deferred Retirement Accounts?
Tax-deferred retirement accounts are more commonly known as pre-tax retirement accounts.
These are a form of tax-advantaged investment portfolio designed to help individuals save for retirement. Depending on the nature of the account, they can either be structured around your employment, such as a 401(k), or self-directed, such as an IRA. In all cases, a tax-deferred retirement account is subject to the rules set by Congress and enforced by the IRS.
How Do Tax-Deferred Retirement Accounts Work?
All tax-deferred retirement accounts share the same basic structure.
You receive a tax deduction for the money you contributed to a tax-deferred account each year. This deduction applies up to the account’s contribution limits each year, after which you cannot put more money into that portfolio until the next tax year. For example, if you are under age 50, the 401(k) limit in 2024 caps your contribution at $23,000.
You can only invest in a tax-deferred retirement account with what’s called “earned income.” In general, this refers to money on which you paid income and employment taxes and restricts funds that you received as an investment return.
Once the money is in this account, you do not pay taxes for any given year’s returns, dividends, interest or other gains. Depending on your plan, the IRS may restrict what kinds of assets the portfolio can hold. It will also restrict when you can withdraw money from this portfolio. Typically, outside of special hardship circumstances and qualified loans, you cannot take money from a tax-deferred retirement account before age 59 1/2. If you do, the IRS will assess a significant tax penalty.
You pay income taxes on all of the money you withdraw from a tax-deferred account. This makes these portfolios different from a taxed account in two critical ways: First, you pay income tax rates, not capital gains rates. Second, you pay taxes on the principal (the amounts you paid in) as well as the returns. To ensure that you pay at least some taxes eventually the IRS requires you to take minimum amounts, known as RMDs, from a tax-deferred account starting at age 73.
The key advantage to a tax-deferred retirement account is lower upfront tax costs. The savings from not paying taxes on your contributions make it cheaper to invest in these portfolios, which in turn can help individuals invest more during their working lives.
For example, say that you earned $100 and paid a 20% tax rate. With a tax-deferred retirement account you could pay $0 in taxes and contribute the entire $100 to your retirement account. But in retirement, say you withdraw $100 and pay a 20% income tax rate. You would pay $20 on your withdrawal and get to keep the remaining $80.
What Are the Kinds of Tax-Deferred Retirement Accounts?
The IRS offers several types of tax-deferred retirement accounts. The most common plans include:
- Individual Retirement Account (IRA)
- 401(k)
- SIMPLE 401(k)
- 403(b)
- SIMPLE Individual Retirement Account
- SEP Individual Retirement Account
- 457(b)
What Are Tax Exempt Retirement Accounts?
It is inaccurate to call any retirement account a tax-exempt account, as the IRS does not offer any untaxed retirement plans. The more accurate term is “post-tax retirement plan.”
These are a form of tax-advantaged investment portfolio designed to help individuals maximize their income while in retirement. Most are self-directed, but some employers will offer post-tax accounts as well. In all cases, a post-tax retirement account is subject to rules set by the IRS.
How Do Tax Exempt Retirement Accounts Work?
The rules of a post-tax retirement account are designed to save you money in retirement in exchange for higher tax costs today.
When you make contributions to a post-tax account, you do not receive a deduction or any other form of tax advantage for this money. You invest in these portfolios with funds on which you have paid income taxes. Like a tax-deferred account, you can only invest in a post-tax account using earned income, which doesn’t include funds that you received from investment returns and securities.
The IRS limits how much you can contribute to a post-tax account each year. For example, in 2024 you can only contribute $7,000 to a Roth IRA.
Once you have invested this money, the IRS restricts when you can withdraw some of it. You can always withdraw your post-tax contributions without paying additional taxes or penalties. But as with a tax-deferred account, typically outside of special hardship situations and qualified loans you cannot take any earnings out of a post-tax retirement account until you turn age 59 1/2.
You pay no taxes on your withdrawals from a post-tax retirement account as long as you follow the rules. This means that the funds in your account can grow entirely tax-free. Since you pay no taxes on this money, the IRS does not require annual minimum distributions.
The key advantage to a post-tax retirement account is maximizing income. Since you pay taxes on the money you use to fund this portfolio, it’s more expensive to save with these accounts than with a tax-deferred account. However, since you pay no taxes on the account’s returns and your withdrawals, you can maximize your income from the portfolio more easily.
For example, say that you earned $100 and paid a 20% income tax rate. With a post-tax account, you would pay $20 in taxes and could invest with the remaining $80. But in retirement, say you withdraw $100 and have a 20% income tax rate. With a post-tax account, you would pay $0 in taxes and could keep the entire $100.
What Are the Kinds of Tax Exempt Retirement Accounts?
There are two main kinds of post-tax retirement accounts:
- Roth individual retirement account (IRA)
- Roth 401(k)
Roth IRAs are self-directed accounts, meaning that you open, fund and manage the account yourself. Roth 401(k)s are employer-directed accounts, meaning that they are only available to individuals who have an employer who will manage the account. Both portfolios operate as a post-tax account.
Bottom Line
Tax-deferred retirement accounts, otherwise known as pre-tax accounts, are retirement accounts which give you a tax deduction for your contributions. While the IRS does not offer any untaxed retirement accounts, post-tax accounts do not give you a deduction for your contributions but they do allow you to make entirely untaxed withdrawals (as long as you follow all the rules).
Tips for Tax-Deferred Accounts
- If you want to open a tax-deferred account and learn hot to best manage one, here’s an overview of some tax-deferred options.
- A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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