Medical professionals considering retirement enter into a world of potential options, opportunities, and pitfalls on their journey. With so many options, however, it can be difficult to determine which is best for you.
One common area that creates confusion—and potentially expensive inaction—is choosing between two different types of retirement accounts: tax-deferred and tax-exempt.
This article serves as an outline of tax-deferred and tax-exempt plans like the 401(k) and the Roth IRA, respectively, to help you understand the difference, benefits, and drawbacks of each as you plan for your retirement.
A tax-deferred account means you don’t have to pay taxes on your contributions this year—the amount you invest gets excluded from your taxable income when you invest. Two of the most common tax-deferred accounts are traditional IRAs and 401(k)s. Whatever you contribute to the account in a yearly span lowers your taxable income for that year. You don’t pay taxes on the money you put into a traditional IRA or 401(k).
This can be a fantastic way to save a great deal of money during working years because you can invest with pre-tax money and that money will grow for you over time. You pay taxes on the growth when you take out the money in retirement.
Because of this dynamic of deferring taxes, tax-deferred accounts are often favored by high-income earners because your tax rate is often higher now than it will be in retirement when you are taking out the money and do not have an earned income. Thus, you might end up paying a lower tax rate in the future than when you deposited the money. When planned correctly, it leads to a relatively low marginal tax rate overall.
Required Minimum Distributions (RMDs)
One caveat to the traditional 401(k), for example, is that, under the current rules, you will eventually need to take the money out and subject it to taxes, so you cannot hold money in a tax-deferred account forever.
Once a taxpayer reaches age 72, they must begin withdrawing a percentage of the money, proportional to life expectancy. RMDs therefore raise a taxpayer’s taxable income every year they withdraw. One must anticipate and plan for RMDs if they want to optimize both their savings and their effective tax rate over a lifetime.
A tax-exempt retirement savings plan means you do not get a tax deduction when you make the investment. You invest with post-tax money. However, because you already paid taxes on the money you invest, the account also grows tax-free.
Two of the most commonly-known types of tax-exempt accounts include the Roth IRA and Roth 401(k). If one contributes to a Roth IRA or Roth 401(k) instead of a traditional IRA or 401(k), they cannot take a tax deduction on the contribution, therefore keeping their taxable income higher than it might be for that year. However, the benefits come later in the form of tax-free withdrawals.
Unlike the traditional IRA or 401(k), these accounts have no RMDs that the person who started the accounts is subject to.
The money grows tax-free, and the taxpayer can withdraw however much or little they want, whenever they want, so long as they are 59½ years of age and have had the account for at least five years.
It may be advantageous to pay into a tax-exempt account like this, especially if you expect tax rates to rise in the future because taxes are essentially paid on the front end. By the time the taxpayer retires, federal and state income taxes may increase—but if the money is tax-exempt, it won’t matter.
Which Retirement Account is Right for You? Tax-Deferred or Tax-Exempt?
Each type of retirement savings account has its own benefits and drawbacks. However, the common advantage is that each confers some kind of tax advantage. Therefore, it may be in your best interest to talk with your wealth advisor about investing some of your income into one, the other, or a mix.
If you want to lower your taxable income during your working years, it may be beneficial to look into the tax-deferred savings account. If you want to ensure more control over your retirement distributions by creating tax-free withdrawals, tax-exempt retirement accounts might be the right fit for you.
To find the best fit for your situation, ask with your Certified Public Accountant (CPA), wealth manager, or financial advisor to walk you through the important details about how these can work in your specific situation.