Is your retirement savings account Tax-deferred or Tax-exempt?
There comes a time in every worker’s lifetime where retirement is inevitable. Definitely, we all have to stop working one day, however, we still need to keep surviving and meeting our daily needs to the best of our abilities without being dependent on others or on the government for benefits. This is why the majority of people think ahead while still working and start a retirement savings plan to keep sufficient resources tucked away for retirement.
Nevertheless, as a responsible citizen, the payment of taxes is your duty and needs to be considered even when choosing a suitable savings account for retirement. The knowledge of tax planning on different types of retirement accounts can help an individual save more money and make an informed decision on the right retirement plan to choose.
Types of retirement savings accounts
There are 2 major types of retirement accounts.
- Tax-deferred retirement accounts
- Tax-exempt retirement accounts
Both retirement savings accounts help individuals to reduce the amount of taxes needed to be paid on contributions towards retirement and make it easy to save sufficiently from an early age in life. However, both types of retirement savings accounts have their individual tax benefits that might be best suited to different individual needs depending on their income level and their present and expected future tax brackets.
However, regardless of which type of retirement savings account is decided on, tax payment is still compulsory, however, the time of payment for the taxes will differ.
Tax-deferred retirement accounts
Tax-deferred retirement accounts are accounts that allow for tax owed on income to be deferred or pushed back to a later date. This means future withdrawals from this savings account will be subjected to the original tax rate on income. Contributions and earnings in this account are still taxable income but left for tax payment on a future date.
In this type of account, money contributed over the years and deposited is not taxed immediately, however, when it is time to make withdrawals, it will be 100% taxable at the ordinary income rate.
As it is known, a retirement savings account grows over time, and earnings is expected on the contributions made over the years. But for the Owner of this account, ordinary income tax will be charged on any withdrawal from this account, whether it be contributions or earnings on the savings account.
A lot of individuals however believe that the tax-deferred retirement accounts are more advantageous due to the fact that there is no immediate tax deduction from contributions made. This further encourages individuals to contribute more to their savings account. This is a good advantage because the higher the savings, the higher the investment made towards the future.
In summary, in a tax-deferred retirement account, taxes are not paid immediately, rather, contributions are made or earnings are recorded. However, taxes are usually pushed up, to be paid in the future when the investor would have expected to have fallen within a lower tax bracket so that an even less amount in taxes will be paid on distribution in later years rather than what would have been paid on contributions while working.
Common examples of tax-deferred retirement accounts include the 401(k) and the 403(b) which have the same contribution limits as that of tax-exempt retirement payment accounts.
Tax-exempt retirement accounts
In tax-exempt retirement accounts, no immediate tax benefit is given during the deposition of funds into the account over time. However, future tax benefits will be provided and no taxes will be demanded when the withdrawal is made at retirement in later years. This means that your investment returns are given an opportunity to grow tax-free.
In summary, for tax-exempt retirement accounts, taxes are paid immediately when payment or contributions are made. This shows that the contribution in the account has already been taxed and no tax payment will be required on the distribution in later years during withdrawals.
Common examples of tax-exempt re accounts are the Roth IRA and Roth 401(k) which have the same contribution limits as that of tax-deferred retirement payment accounts.
What is the best retirement savings account?
No retirement savings account can be particularly said to be the best, as they both have their unique benefits. The suitability of each one depends on the individual circumstances of workers. The most suitable retirement savings account depends entirely on the income level, the present, and the expected tax bracket of the individual.
Individuals with high income presently usually prefer to choose the tax-deferred retirement accounts over the tax-exempt retirement accounts. This is because, at the initial period of contributions, the tax bracket these individuals fall into might require high tax Income payment on contributions. But after retirement, they would fall into a lower tax income bracket and tax payment required on income will be significantly reduced.
Individuals with low income however always prefer tax-exempt retirement accounts, because their income tax bracket will be lower at this initial contribution stage, but might increase in the future. Therefore, the account gives them a future free of tax payments on withdrawal from the retirement account irrespective of the tax bracket they would fall into in the future.
Nowadays, the majority of workers prefer having both the tax-deferred retirement savings account and the tax-exempt retirement savings account and take advantage of the complimentary benefits that they both offer. However, to get the best plan that suits you perfectly, you might want to speak to a financial advisor to be sure about the best retirement savings account for your unique situation.
A financial advisor will put you through the technicalities of operating both a tax-deferred and a tax-exempt retirement savings account and advice you on the best path for you, based on the specifics of your circumstances.
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