Tax-Deferred or Tax-Exempt? Potential Benefits to Having Both

Over the years, you may have heard it’s good to have different “kinds” of money as you head into retirement. A financial advisor may recommend a combination of tax-deferred and tax-exempt accounts, diversifying your money to help take advantage of the tax benefits both types of products provide.

What many people don’t understand, however, is why it’s important to take advantage of the different types of accounts available. What are the potential benefits of utilizing both tax-deferred and tax-exempt accounts? First, let’s take a look at the difference between the two.

A tax-deferred financial accounts means simply that: You owe taxes on the money, but those taxes have been deferred or pushed back. You haven’t paid any taxes on the contributions or the growth that’s occurred over the life of the account. When you take money out of it, those distributions are 100 percent taxable at ordinary income rates.1 Withdrawals taken prior to age 59 1/2 may also be subject to an additional 10 percent federal tax.

What types of financial accounts are tax-deferred? A 401(k), 403(b) or traditional IRA are all examples of tax-deferred investment accounts. Growth in some types of annuities or life insurance policies may also be tax-deferred.2

Tax-exempt means no taxes are owed on qualified distributions made from the account. A Roth IRA or Roth 401(k) is a good example of a tax-exempt account. Contributions to a Roth are made with money that’s already been taxed.3

So why can it be beneficial to have a mix of tax-deferred and tax-exempt accounts in your financial strategy? Mostly, it gives you flexibility in how you take distributions during your retirement. For example, you might use distributions from tax-deferred accounts to pay for your fixed expenses every month. If you have expenses that are outside of your “normal” spending -- such as a vacation or a large purchase -- you could use money from a tax-exempt accounts and not incur a taxable event.

While it could be tempting to go heavy in tax-exempt accounts when you’re establishing a financial strategy, using a tax-deferred accounts may put more money in your pocket in the long run. Many people are in a lower tax bracket during their retirement years. If that is the case, you may pay less taxes on distributions during retirement than if you were paying taxes on your contributions up front while still working.4

What’s the right mix of tax-deferred and tax-exempt accounts for you? Every situation is unique. If you’re not sure what types of accounts you should be using, give us a call. We can look at your existing financial strategy and make recommendations based on your specific circumstances.

Content prepared by Amy Ragland

1 The Balance. “What is a Tax-Deferred Investment Account?” https://www.thebalance.com/tax-deferred-savings-account-and-investments-2388988. Accessed May 31, 2017.

2 Prudential. “Tax Strategies: Tax-Deferred Annuities.” http://www.prudential.com/view/page/public/12609?param=12624. Accessed June 1, 2017.

3 Teresa Mears. U.S. News & World Report. Dec. 19, 2014. “7 Retirement Savings Accounts You Should Consider.” http://money.usnews.com/money/personal-finance/articles/2014/12/19/7-retirement-savings-accounts-you-should-consider. Accessed May 31, 2017.

4 Arthur Pinkasovitch. Investopedia. “Retirement Savings: Tax-Deferred or Tax-Exempt?” Updated April 5, 2017. http://www.investopedia.com/articles/taxes/11/tax-deferred-tax-exempt.asp. Accessed May 31, 2017.

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We are an independent firm helping individuals create retirement strategies using a variety of insurance and investment products to custom suit their needs and objectives. This material is intended to provide general information to help you understand basic financial planning strategies and should not be construed as financial advice. All investments are subject to risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. 

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