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Introduction
When it comes to planning your retirement, taxes are a big deal. Will you pay them now, pay them later – and, ultimately, how will you pay as little as possible? While tax-free retirement accounts do exist, they are governed by precise limits and rules, so you’ll need to be smart about how you use them if you decide they’re the right retirement vehicle for you.
I’ve outlined below the key things you should know about tax-free retirement plans.
What is a tax-free retirement plan?
How tax-free retirement plans work
Pros
Cons
Is a tax-free retirement plan right for you?
Now let’s take a closer look at each one of these areas.
What is a tax-free retirement plans?
Bottom line? A retirement plan can be classified as tax-free if there are no federal or state taxes due on it – either when the income originally is earned within the account or when that income is withdrawn. At present, there is only one type of tax-free retirement plan, and that is the Roth IRA or the Roth 401(k) plan. What does that mean for you? It means you can invest your money in either of these vehicles and watch it grow, tax-free, while also retaining the ability to withdraw it in the future with no tax penalty at that time, either.
And here’s a key point: it’s only the Roth IRA that is tax-free. Traditional IRAs are tax-deferred, which simply means that, while income earned within the account isn’t taxed when it is earned, future withdrawals will be taxed at that time. So in actuality, a traditional IRA simply delays the date when taxes are due.
When your consider your overall tax strategy for retirement, you may be better off by maximizing your contributions to both kinds of accounts.
How tax-free retirement plans work
As you can likely imagine, a tax-free retirement plan is extremely valuable for investors, but not so much for the IRS. As such, they are subject to stringent rules regarding contribution limits, income restrictions and withdrawal rules. For example, if your modified adjusted gross income is too high, you won’t be allowed to contribute to a Roth IRA.
So, what are the limits? For 2021, the income limit for single earners is $140,000, and for married couples, the income limit is $208,000. If you make at least this much money, you won’t be able to open a tax-free retirement plan. In addition, the total amount you can contribute to a tax-free retirement account changes. As of 2021, the contribution limit is $6,000 for investors under age 50 – those older than 50 can deposit up to $7,000 per year.
And here’s something to note: you generally cannot claim tax deductions for your tax-free account – since the key benefit is being able to avoid taxes on the account’s income.
Pros
What’s great about tax-free accounts? First of all, they’re tax-free, right? All your investment earnings can grow tax-free and be withdrawn with no tax penalty. That’s an amazing pro. There’s also no required minimum distribution, unlike with a tax-deferred account. So you get to choose when to start withdrawing your earnings.
And here’s an added bonus: you can withdraw your account contributions (not earnings) at any time without paying taxes on it, so it can also serve as an emergency savings account if you need it.
Tax-free accounts like a Roth IRA are smart choices for younger investors who are still in school or just starting out at work. Because their taxable income and assigned tax bracket are lower, they stand to realize tremendous benefits in the future as their accounts earn income tax-free.
Tax-free accounts also are good for low income earners – assuming they will be subject to a higher tax bracket in the future, the tax benefits could be dramatic.
Cons
Tax-free accounts can’t be all roses, can they? In fact, tax-free retirement accounts aren’t a magical solution. While they offer tremendous benefits, they also come with very strict rules about what you can do with your money and when. Contribution amounts are pretty low, and you aren’t eligible for these accounts if you earn too much money.
In addition, they offer no immediate tax benefit since they are funded with after-tax dollars and you cannot claim a tax deduction related to your contributions. You also have to set up a tax-free account on your own, whereas a traditional 401(k) can be automatically set up through an employer.
Tax-free accounts may not be the best for high income earners. Those with high incomes likely should choose tax-deferred options like traditional IRAs over tax-free versions. Their immediate tax benefit can lower today’s tax bracket, which is a key benefit.
Is a tax-free retirement plan right for you?
Here’s the deal: this is one you have to decide for yourself, hopefully with the help of a trusted financial adviser. Factors to consider include your current tax bracket and your expected tax bracket for the future.
And here’s something else: think carefully about the timeframe and the purpose of your savings vehicle. Most investors typically choose tax-deferred options for retirement since they likely won’t need to withdraw any earnings in the short term. However, tax-free options may make better sense for investments that allow the investor to withdraw earnings on a tax-free basis.
Ultimately, the best retirement strategy doesn’t rely on one type of account. Instead, it likely includes a mix of tax-free options like a Roth IRA or Roth 401(k), and tax-deferred choices like a traditional IRA or 401(k). There’s no one magical choice that will lower your lifetime tax burden. But used together, both types of accounts can help you realize tax benefits today while lowering your tax burden for future withdrawals.
With more than 20 years’ experience securing the future of families and businesses across the country, we have the skills and expertise needed to help you begin laying the foundation for a life of prosperity. Our financial advisors are just a phone call away. Call us at 407-344-1228.
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