Tax-Free vs. Tax-Deferred Plans

Investing in retirement usually involves a bit of strategy, which a team of financial advisors can help with. One topic the advisors will probably discuss is investing in tax-free accounts vs. tax-deferred plans.

What’s the difference and how does it affect retirement investments?

Tax-Free Plans

The money earned in the accounts will be tax free when withdrawn, as long as specific conditions are met. Common tax-free accounts include Roth IRAs, 529 College Savings Plans and Coverdell education savings accounts.

The money initially deposited into these accounts occurs post taxes, and these accounts are not included in income tax deductions. As the accounts earn interest, that interest will not be taxed when withdrawn according to the stipulations of the account.

Tax-Deferred Plans

These accounts will require the investor to pay taxes on the money withdrawn from the accounts, but not on the money earned through the investment each year.

Common types of tax-deferred accounts include Traditional IRAs and 401(k)s – typically offered as employer-sponsored retirement plans. Sometimes these accounts allow investors to contribute money through the employer prior to it being taxed as well.

Because the money in these accounts can accumulate without taxation, investors often have a goal to grow the money in the account faster.

It’s Possible to Move from Tax-Deferred to Tax-Free

Investors also may want to investigate with their team of advisors the option of converting a tax-deferred account into a tax-free account.

When transferred, there will be taxation on the money coming from the tax-deferred account; however, it will be at the current tax prices and the current amount being transferred.