In this article:
- What Is a Tax-Deferred Retirement Account?
- Pros and Cons of Tax-Deferred Retirement Accounts
- Tax-Deferred vs. Tax-Exempt Retirement Accounts
- 3 Types of Tax-Deferred Accounts
Tax-deferred retirement accounts allow you to save for the future while reducing your taxable income today. Your funds will also grow tax-free, and you won't be taxed until you make withdrawals. Tax-deferred retirement accounts have their advantages, but there are certain drawbacks that could impact your finances. Let's take a look at how they work so you can determine if they're right for you.
What Is a Tax-Deferred Retirement Account?
Popular tax-deferred retirement accounts include 401(k)s and traditional individual retirement accounts (IRAs). They're structured a little differently, but both offer a tax-friendly way to approach long-term saving. These types of accounts allow for tax-deductible contributions. Your balance is also sheltered from taxes until you take money out of the account. At that point, your withdrawals will be taxed as ordinary income. The amount you pay will depend on your tax bracket.
That's different from other investment accounts. If you have money in a brokerage account, for example, you'll likely be taxed on investment gains during the year they're realized—even if you keep that money in your account. But this sort of taxable account, as it's called, offers greater flexibility. There are no contribution limits, early withdrawal penalties or required minimum distributions (RMDs).
Pros and Cons of Tax-Deferred Retirement Accounts
Tax-deferred retirement accounts provide a variety of benefits, but there are some drawbacks.
Pros
- Tax-deductible contributions: You can subtract your contributions from your taxable income, which could reduce your tax liability and potentially move you into a lower tax bracket.
- Tax-free growth: You won't be taxed on dividends, interest or capital gains until you withdraw money from a tax-deferred retirement account.
- Potential employer match: If you're saving through a 401(k), many employers will match some or all of your contributions. The average employer match is 4.8%, according to Fidelity Investments, an amount that can add up over the years.
Cons
- Contribution limits: In 2023, you can contribute up to $22,500 to a 401(k). IRA contributions are capped at $6,500. Workers who are 50 and older are also eligible for additional catch-up contributions. Health savings accounts (HSAs), which we'll unpack in a moment, have their own contribution limits.
- Early withdrawal penalties: Withdrawing funds from a 401(k) or traditional IRA prior to age 59½ usually triggers a 10% early withdrawal penalty. If you use HSA funds for anything other than qualified medical expenses, and you're under 65, you'll be hit with a 20% penalty.
- RMDs: If you have a 401(k) or traditional IRA, you'll be required to take minimum distributions beginning at age 73. Otherwise, you could be on the hook for a 25% penalty. (HSAs are exempt from these rules.) These mandatory distributions could create a significant tax burden in retirement.
Tax-Deferred vs. Tax-Exempt Retirement Accounts
With tax-deferred retirement plans, you aren't avoiding taxes—you're simply delaying them. Instead of paying taxes now, you'll pay them when you make withdrawals in retirement. Tax-exempt retirement accounts are different because they're funded with after-tax dollars.
A Roth IRA is a good example of a tax-exempt account. You can withdraw your contributions at any time, tax- and penalty-free, as long as you've had the account for at least five years. However, you may be penalized for tapping your earnings before age 59½. RMDs are not required, unless you have an inherited Roth IRA. Roth 401(k)s have different rules, but RMDs are off the table. One disadvantage of tax-exempt accounts is that your contributions are not tax-deductible.
3 Types of Tax-Deferred Accounts
- Traditional 401(k): This is an employer-sponsored retirement plan that's usually funded through automatic payroll deductions. Many companies offer a 401(k) as an employee benefit. Self-employed folks can get similar tax benefits with a solo 401(k).
- Traditional IRA: These are available through brokerage firms, so investors can open and fund them without their employers' involvement. Contribution limits are much lower when compared to a 401(k), but it can be a nice way to supplement your nest egg.
- HSA: Health savings accounts are designed for people who are enrolled in high-deductible health plans. You're entitled to tax- and penalty-free withdrawals if you use HSA funds for qualified medical expenses. In 2023, individuals on a solo health plan can contribute up to $3,850. The contribution limit for family plans is $7,750. Once you turn 65, you can use HSA money for whatever you want, though you'll be taxed on nonqualified withdrawals.
The Bottom Line
Tax-deferred retirement accounts have some nice tax benefits. Contributions are tax-deductible, and you won't get a tax bill until you take money out of the account. That could come in handy during your working years, but early withdrawal penalties and required minimum distributions apply.
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