Tax-Deferred vs. Tax-Free: Understanding When You Pay
Most retirement accounts fall into two categories based on when you pay taxes: tax-deferred (Traditional) and tax-free (Roth).
- Tax-deferred accounts, like a Traditional IRA, give you a tax break upfront and require you to pay taxes when you withdraw funds.
- Tax-free accounts, like a Roth IRA, require you to pay taxes upfront, but withdrawals in retirement are tax-free.
Knowing which type your retirement savings fall into can help you plan contributions, withdrawals, and your overall tax strategy.
How Tax-Deferred Accounts Are Taxed
Tax-deferred accounts include Traditional IRAs and most employer-sponsored plans, such as 401(k)s, 403(b)s, and 457 plans. They are typically funded with pre-tax dollars and follow similar tax rules.
Contributions may lower your taxable income, and your investments grow without annual taxes. Taxes are due when you withdraw money, with withdrawals taxed as ordinary income based on your tax bracket. This approach often works well for people who expect to be in a lower tax bracket in retirement.
How Tax-Free Accounts Are Taxed
With tax-free accounts, such as Roth IRAs and Roth 401(k)s, contributions are made with after-tax dollars.
Qualified withdrawals in retirement, including contributions and investment earnings are tax-free, as long as you are at least 59½ and the account has been open for at least five years. This structure can be ideal for people who expect a higher tax rate later in life or want more flexibility in retirement.
How Rollovers Are Taxed
A rollover lets you move retirement savings from one account to another without triggering taxes, as long as the money goes into an account with the same tax treatment.
In a direct rollover, the money is sent straight from your old account to your new account, which is generally tax-free. In an indirect rollover, the money is sent to you first. You must deposit it into the new account within 60 days to keep it tax-free. Missing this window can make the rollover taxable and subject to penalties.
Roth conversions are different. If you move money from a pre-tax account into a Roth account, the converted amount is added to your taxable income for the year.
