Tax-exempt accounts don't have tax benefits when you contribute to them, but in the future, they provide tax benefits. The contributions into the account are made from after-tax dollars, but there are no immediate tax advantages. The primary advantage of this is that investment returns and grows tax-free.
A benefit of the tax-exempt account is investing the money into the market. You will be able to access these funds along with any additional income like interest without it being taxed. This type of account is tax-free when you take the money out for retirement, so it won't push you into a higher tax bracket.
A tax-deferred account is a financial account where you pay taxes on withdrawals at some point in the future. Some taxes can be deferred indefinitely, while other people may be taxed at a lower rate in the future. The taxpayer and corporations may defer certain taxes like retaining corporate profits overseas is also a form of tax deferral.
The immediate advantage of this account is that you are paying less tax in the current year which provides a strong incentive for many individuals to fund a tax-deferred account. The immediate tax benefit of the current contribution outweighs the negative tax implications. The higher earners typically strongly encourage maxing out their tax-deferred accounts to minimize their current tax burden since they might have a smaller tax bracket as they stop working in the future.
Choosing the Right Account:
The low-income earners are encouraged to focus on funding a tax-exempt account. Since they do not earn enough to qualify for a higher tax bracket, being taxed now versus in the future when they may be taxed more is beneficial.
The high-income earners may focus more on contributions to a tax-deferred account such as 401(k) or the traditional IRA. The benefit of this is that because they are in a higher tax bracket due to how much they earn, when they withdraw their retirement savings in the future, they would be in a lower bracket and so less tax would be collected overall.
What is 401(k):
401(k) plans are employer-sponsored savings accounts specifically for retirement savings. Employees elect how much they want to contribute to their 401(k) plans. For more information, look at our post on 401(k)s.
Traditional IRA or Roth IRA:
The traditional IRA is a tax-deferred account where you pay no taxes on the money you put in until you withdraw it. The money you deposit into a Roth IRA has already been taxed as it is a tax-exempt account.
Written by Anna Li