Tax-Deferred vs. Tax-Exempt Retirement Accounts: Key Differences

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What Is a Tax-Deferred Retirement Account?

Tax-deferred retirement accounts, such as 401(k)s and traditional IRAs, offer a tax-efficient way to save for the future. These accounts allow for tax-deductible contributions, and your funds grow tax-free until you make withdrawals. At that point, your withdrawals are taxed as ordinary income based on your tax bracket.

Pros and Cons of Tax-Deferred Retirement Accounts

Pros

• Tax-deductible contributions: Contributions can be subtracted from your taxable income, potentially reducing your tax liability and moving you into a lower tax bracket.
• Tax-free growth: Dividends, interest, and capital gains are not taxed until you withdraw money from the account.
• Potential employer match: Many employers match contributions to 401(k) plans, which can significantly boost your retirement savings over time.

Cons

• Contribution limits: In 2023, the contribution limit for a 401(k) is $22,500, while IRAs are capped at $6,500. Additional catch-up contributions are available for those aged 50 and older.
• Early withdrawal penalties: Withdrawing funds before age 59½ usually incurs a 10% penalty for 401(k)s and traditional IRAs. HSAs have a 20% penalty for non-medical withdrawals if you’re under 65.
• Required Minimum Distributions (RMDs): Starting at age 73, you must take minimum distributions from 401(k)s and traditional IRAs, or face a 25% penalty. HSAs are exempt from RMDs.

Tax-Deferred vs. Tax-Exempt Retirement Accounts

Tax-deferred accounts delay taxes until withdrawals are made in retirement, while tax-exempt accounts, like Roth IRAs, are funded with after-tax dollars. Roth IRAs allow tax- and penalty-free withdrawals of contributions at any time, provided the account has been open for at least five years. However, earnings may be penalized if withdrawn before age 59½. Roth 401(k)s have different rules but do not require RMDs.

3 Types of Tax-Deferred Accounts

Traditional 401(k)

This employer-sponsored plan is typically funded through automatic payroll deductions. Self-employed individuals can benefit from similar tax advantages with a solo 401(k).

Traditional IRA

Available through brokerage firms, traditional IRAs can be opened and funded without employer involvement. Contribution limits are lower than 401(k)s, but they can still be a valuable addition to your retirement savings.

Health Savings Account (HSA)

HSAs are designed for individuals with high-deductible health plans. Contributions are tax-deductible, and withdrawals for qualified medical expenses are tax- and penalty-free. In 2023, individuals can contribute up to $3,850, and families can contribute up to $7,750. After age 65, HSA funds can be used for any purpose, though non-medical withdrawals will be taxed.

The Bottom Line

Tax-deferred retirement accounts offer significant tax benefits, including tax-deductible contributions and tax-free growth. However, be mindful of early withdrawal penalties and required minimum distributions. As you plan for retirement, consider monitoring your credit health to protect against identity theft and other financial risks.

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