Tax Planning Ideas and Tax Updates

Types of Retirement Accounts: The Three Tax Treatment Buckets

by Alli Thomas

Mar 3, 2023

When thinking about the types of retirement plans available, most people think in terms of specifics — traditional and Roth IRAs, 401ks, etc. But retirement accounts can also be grouped by how they’re treated for tax purposes by the Internal Revenue Service. These three types are: tax-deferred, tax-free, and taxable — with the first two offering specific tax advantages.

If you’re among those that isn’t sure which taxation type your accounts fall under or are wondering which one you should put your retirement savings into, here is a primer on each.

The Three Retirement Account Types

Tax-deferred accounts 

Tax-deferred accounts include employer-sponsored retirement plans such as 401(k) plans and traditional IRAs. Contributions to these accounts are made pre-tax and reduce your taxable income for the current tax year since, as the name implies, taxation of the money in the account is deferred until later.

  • If you believe you’ll be in a lower tax bracket in retirement than you are now, these accounts are a good option for your retirement savings plan.
  • Contributions to tax-deferred accounts are not taxed until money is withdrawn.
  • You may contribute to employer-sponsored tax-deferred plans through payroll deductions. As long as you are working for the company or entity that sponsors the plan, you can put money into it.
  • Employer contributions are typically made into tax-deferred accounts.
  • Withdrawals are considered taxable income.
  • You must take required minimum distributions from tax-deferred accounts upon reaching age 73.
  • A tax-deferred account may have an contribution limit, but there are no income limits. However, if you earn above a certain amount and have an employer-sponsored retirement account, contributions you make to a traditional IRA may not be tax-deductible though you can still contribute to the IRA for the benefit of tax-deferred investment earnings.

Tax-free accounts 

Tax-free accounts include Roth IRAs, Roth 401(k), Roth 403(b), and Roth 457 plans.

  • If you think you (or your beneficiary) will be in a higher tax bracket at the time of withdrawal than you are now, these accounts may be a good option for you.
  • You contribute after-tax dollars to these accounts (money you already paid taxes on), but under certain conditions, you will not pay taxes on withdrawals from these accounts and your money grows tax free.
  • There is no required minimum distribution age for a Roth IRA, but the RMD does apply to employer-sponsored Roth accounts. You could opt to take this RMD and then roll over to a Roth IRA to keep it invested.
  • There is no age limit to contribute to a Roth IRA. You may hold on to it until you die without tapping it, at which point your beneficiary will receive the account and can take tax-free withdrawals from it.
  • The Roth IRA is subject to annual contribution limits AND income limits. In other words, you can’t contribute to a Roth IRA if you earn over a certain amount.

Read More: Have You Heard About the “Rich Person’s Roth?”

Taxable accounts 

Taxable accounts include everything else, such as bank accounts and brokerage accounts.

  • There are no tax benefits (either today or in the future) for funding taxable accounts.
  • However, they are generally more flexible than either both tax-advantaged account types
  • There are no contribution limits and no penalties on withdrawing money from these accounts.
  • There are, however, capital gains taxes you’ll pay when you withdraw from these accounts. If you’ve held your investment in a brokerage account for less than one year, a withdrawal will be subject to short-term capital gains (which can be high—up to 37%). If you’ve held the investment for more than one year and withdraw it, it will be taxed at a lower rate, called long-term capital gains. Depending on your tax bracket, that rate could be between 0% and 20%.

Leverage All Three to Minimize Taxes

Many financial experts agree that strategic tax planning is the way to go when investing for retirement. Depending on several factors that are unique to you and the retirement planning strategy you follow, contributing to a combination of tax-deferred, taxable and tax-free accounts can reduce the tax bill on your retirement income once you start making withdrawals.

Given the number of retirement savings options available, many people have a hard time figuring out how to distribute contributions across different types of accounts. Working with an experienced financial advisor can simplify the process, and a good advisor can make sure that you are properly diversified. Our advisors are available for a free consultation on your retirement tax planning strategy! Click here to set up a no-obligation meeting today.

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Alli Thomas

Alli Thomas has worked in the financial services industry for nearly 20 years, with a focus on retirement-related investing. She began her career as a FINRA-licensed participant-services call-center associate at Vanguard, and then moved to Principal Financial Group, where she worked closely with employers, assisting with retirement plan set-up and design, selecting appropriate plan investment offerings, and maximizing employee participation through targeted education campaigns and enrollment meetings. Alli has also worked as a qualified 401(k) administrator and registered investment advisor for several small investment firms. She now writes about all things investment- and finance-related, leveraging her extensive experience and passion for retirement planning to help investors make well-informed financial decisions.

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