When do You Want to Pay Taxes?
You have a choice when saving for retirement
Now or later?
When weighing retirement investment options and your tax responsibilities, your answer to this question is pivotal.
Do you want to pay taxes while you are working and socking away funds for retirement, or pay taxes when you stop working and begin withdrawing those saved funds?
Your answer determines if you will use tax-deferred accounts or tax-exempt accounts.
Tax-deferred accounts are funded with monies that pay taxes later – when the money is taken out for spending. This strategy potentially creates a situation in which the saver’s income falls within a lower income tax bracket than during his or her working years – thus generating a decreased tax bill.
Tax-exempt accounts are funded with money that already paid the IRS and do not incur any taxation when it comes time to use the funds. The amount paid into the account is deducted from that year’s income thus reducing the savers future tax burden.
That is the basic difference between a tax-deferred account and a tax-exempt account.
While the difference is rudimentary, the decision is far from that.
Before we look at these two types of retirement savings vehicles in greater detail, here is a bit of good news to frame the decision-making process within.
“Just to be clear, both types of retirement account[s] minimize the amount of lifetime tax expenses someone will incur, which provides incentives to start savings for retirement at an early age,” wrote Arthur Pinkasovitch, a chartered financial analyst, in a recent Investopedia article addressing the differences between the two types of retirement accounts. “The most distinct difference between the two types of accounts is when the tax advantages kick in.”
Tax-Deferred Accounts
Long considered the darling of retirement savings, tax-deferred accounts were created in 1974 under the federal Employees Retirement Income Security Act (ERISA). Originally not tax-deductible, contributions nationwide quickly rose to $1.4 billion in 1975 and to $4.8 billion by 1981, according to a historical narrative at FinancialDucksInARow.com.
The best known of these are the traditional IRA (Individual Retirement Account) and the 401K – the later of which is most generally available via employer sponsorship.
Other types of tax-deferred accounts include bonds, certificates of deposit, fixed annuities, mutual funds, stocks, variable annuities and whole life insurance.
Growth in the value of a tax-deferred account generated by interest is not subject to taxation as “investment income,” thus setting up a scenario in which original funds can grow without immediate tax consequences.
For example: A $1,000 deposit for which a five percent interest rate is paid results in an extra $50. In the subsequent year when the hypothetical five percent of interest is applied to the account’s value of $1,550, an additional $52.50 is tacked on. The account total value is now $1602.50.
Those are small numbers.
Let’s look at what happens when $5,000 is set aside. That’s not a far stretch considering the 2020 limit set by the federal government for tax-deferred IRA accounts is $6,000 for most savers and $7,000 for those age 50 and above playing catchup.
A $5,000 investment at five percent interest creates $250 interest in the first year. In the second year, the $5,250 at five percent interest generates $262.50 in interest bringing the account total to $5,512.50. In ten years, that initial $5,000 is now $8,157. In 20 years, the $5,000 you started with is now worth $13,299 thanks to the addition of $8,279 of interest.
Again, those are small numbers – a large portion of retirement accounts have much greater numbers. But let’s tax a look at the opportunity deferring taxes on that $5,000 presents.
Hypothetically again, let’s assume Taxpayer Joe has $200,000 in income for 2020. That puts him in the 32 percent tax bracket, according to the IRS, and leaves Taxpayer Joe owing $64,000 in taxes before deductions, etc.
Contributing $5,000 to his IRA reduced his current income to $195,000 but he is still in the 32 percent tax bracket meaning before deductions, etc., his tax bill is $62,400 for a savings of $2,600.
Assuming that tax brackets remain similar – although don’t count on that as Vegas odds on taxes going down are slim to none – and in his retirement at least 20 years down the road, Joe Taxpayer’s annual income drops to $75,000 putting him in the 22 percent tax bracket.
When he withdraws the original $5,000, his tax bill if $500 less (at 22 percent) in his retirement than it would have been in his working years at 32 percent.
Deduct that $500 in tax in his retirement years from the $13,299 Joe Taxpayer earned by investing and not touching the initial $5,000 for 20 years and his ability to let the money grow earned him $12,799.
Of course, all of this is just one “what-if” scenario in using tax-deferred accounts to fund retirement and is highly dependent on prevailing interest rates and government action regarding tax brackets. These numbers are significantly larger when looking at the opportunities in a 401(k) that is tax-deferred. The 2020 limit for that type of account is $19,500 (plus $6,500 for those age 50 and older in catchup mode)
The downside to tax-deferred accounts is the ten percent withdrawal penalty if such is done before age 59.5.
Fair Warning
There is movement in Congress to eliminate tax-deferred retirement accounts – at least the catchup portion of such.
The Securing a Strong Retirement Act of 2021 passed the U.S. House Ways and Means Committee on May 4, 2021. If passed by the U.S. Senate and signed into law by President Biden, it raises the age of minimum required distribution from 72 to 75 by 2032, according to reporting in USA Today. It also makes auto-enrollment mandatory and forces those not wanting to auto-enroll to opt out. One provision allows employers to match the dollar amount of employee’s student loan payments.
However, the provision that raises some eyebrows within the financial services industry is one requiring “catchup” funding to be done via Roth accounts that do not allow for deferred tax payment.
Calling it the “Rothification” of retirement, Jamie Cox, a financial advisor and managing partner with Harris Financial Group based in Richmond, Virginia, told ThinkAdvisor.com that savers in catchup mode (those age 50 and older), “will no longer be allowed to” make tax-deferred contributions.
He believes that requirement in what is being dubbed, “Secure Act 2.0,” is testing “the waters” to see how investors/savers will respond. He sees it tied to the government’s scrabble for additional revenue.
“That’s a big part of the revenue raise,” he told ThinkAdvisor in a recent article. “This particular concept has come up multiple times and is called ‘Rothification.’”
At this point, the House bill has a long road ahead of it before becoming law. It has to pass the full House, then go to the Senate for its committee meetings, then full Senate vote and most likely a hammering out of differences between the two law-making bodies before heading to the White House. Yet, it is prudent to keep tabs on its progress and note the changes it would bring.
Tax-Exempt Accounts
The contribution limits for tax-exempt accounts are the same as for tax-deferred accounts. 
The tax-exempt accounts have the word “Roth” in front of them. “Roth” recognizes Senator William V. Roth of Delaware who championed this new type of investment vehicle in the Taxpayer Relief Act of 1997.
Other examples of tax-exempt accounts include 403(b) plans sponsored by employers, 529 education funds, 1031 exchanges, health savings accounts, Indexed Universal Life Insurance policies, municipal bonds, tax-free EFTs (Exchange Traded Funds) and U.S. Series savings bonds.
The beauty of tax-exempt accounts is that once the taxes are paid upfront before contribution, the account grows based on its applicable interest rate. Savers using this method don’t have taxation concerns when withdrawing funds.
It Doesn’t Have to Be Either Or
Some investor/savers opt for both.
There is no law against having monies in both types of accounts.
“Many investors have both taxable and tax-advantaged accounts so they can enjoy the benefits each account type offers,” wrote Jean Folger, co-founder and managing partner of PowerZone Trading, LLC, based in Asheville, North Carolina, in an Investopedia article.
