Tax-Free and Tax-Deferred Retirement Accounts should be part of your retirement strategy. We will discuss the characteristics of different investment vehicles and demonstrate the importance of tax-sheltered growth for retirement savings.
Table of Contents
Retirement Finance Fundamental
- The best types of income are tax-free and tax-deferred
Investment Vehicles
Personally Established Accounts Are Available to All. You may not have yet established a company retirement plan as a small business owner. And even if you have, you should also start your own retirement accounts to help fund your future. Individual Retirement Accounts (IRAs) are retirement investment vehicles that are widely available and extremely easy to set up.
Roth IRA (after-tax investment, tax-free growth, tax-free withdrawals)
A Roth IRA should be your default retirement choice if you qualify. Although it won’t help lower your taxes in the year you contribute, funds in the account grow tax-free. And withdrawals are also tax-free if taken at age 59 1/2 (or older) from an account held for five years. In addition, Roth IRAs have no minimum required distributions.
Traditional IRA (pre-tax investment, tax-deferred growth, taxable withdrawals)
Contributions into traditional IRAs are tax-deductible in the current year. After that, funds in the account grow tax-deferred (you don’t pay taxes on interest, dividends, or capital gains). However, traditional IRAs have required minimum distributions starting at age 72, and all withdrawals from the IRA will be taxed as income at your marginal tax rate.
Traditional Brokerage Account (after-tax investment, taxable growth)
You make contributions into traditional brokerage accounts with after-tax dollars. Funds in the account do not grow tax-deferred (you will pay taxes on interest, dividends, and capital gains annually).
“A Roth IRA is one of the superheroes of retirement accounts… Do not pass up the good deal of a Roth IRA.”
Personal Finance, Garman/Forgue
Tax Diversification
Will taxes rates go up over your retirement planning horizon? Will you be in a higher tax bracket when your retire than you are today? Or do you expect to be in a lower tax bracket in retirement than your prime earning years?
Because none of us have a crystal ball, tax diversification helps to mitigate the risk inherent in this uncertainty. Therefore, having both before-tax and after-tax investment vehicles in your retirement portfolio is essential.
Tax-Free and Tax-Deferred Retirement Accounts Grow Faster
Betsy, Barney, and Bonnie are therapists who earned their certifications simultaneously. They started at different nonprofits but eventually, each started a private practice. They all want to secure their financial future, but each has chosen a different investment vehicle for their retirement savings:
- Betsy – Roth IRA (Tax-free),
- Barney – SEP IRA (Tax-deferred)
- Bonnie – Traditional brokerage account (Taxed)
Betsy and Bonnie both invest with after-tax dollars, while Barney can claim a current-year income reduction by investing pre-tax dollars.
Barney and Betsy both enjoy tax-sheltered growth (accelerating the increase in their funds), while Bonnie is taxed on her earnings at her marginal tax rate each year.
Bonnie and Betsy can both take withdrawals without worrying about any tax considerations, while Barney must pay regular income tax on his withdrawals.
Which nest egg would you rather have at retirement?
Betsy (Roth IRA):
- Starting salary = $55,000
- Savings rate = 7% of salary (after-tax dollars)
- Salary growth = 3% annually
- Interest = 8% APR
- 37 years of consistent savings
- Value at retirement = $1,215,207
Barney (SEP IRA)
- Starting salary = $55,000
- Savings rate = 7% of salary (pre-tax dollars)
- Salary growth = 3% annually
- Interest = 8% APR
- 37 years of consistent savings
- Tax rate at retirement = 22%
- Value at retirement = $947,861
Bonnie (Traditional brokerage):
- Starting salary = $55,000
- Savings rate = 7% of salary (after-tax dollars)
- Salary growth = 3% annually
- Interest = 8% APR
- Marginal tax rate = 24%
- 37 years of consistent savings
- Value at retirement = $784,563
Bonnie is the clear loser in this scenario. She will have 17% ($163K) less than Barney and 35% ($431K) less than Betsy at retirement.
Tax-Deferred Retirement Accounts Grow Faster Than Traditional Brokerage Accounts
If Barney takes a lump-sum distribution at retirement, he will owe tax on that income ($267K at his marginal rate in retirement). But the power of tax-deferred growth (via the SEP-IRA) will have helped his nest egg grow $163K bigger than Bonnie’s.
Tax-Free Retirement Accounts – Winner, winner, chicken dinner!
Betsy is the clear winner. Her $1.2M nest egg demonstrates the power of the Roth IRA (tax-free growth + tax-free withdrawals). So even though you take a tax hit up-front, Roth IRAs almost always overcome that initial burden, and you will escape taxes completely in your retirement years.
Related Articles
- How to Earn an Additional $1M in Retirement Savings
- Why Start a Company Retirement Plan
- Myths That Prevent Business Owners from Starting a Retirement Plan
- How to Establish Your Retirement Strategy
Sources
- Personal Finance, E. Thomas Garman, Raymond E. Forgue
- Roth IRA Rules and Contribution Limits for 2021 | Good Financial Cents
- Best Places To Open A Roth IRA | Good Financial Cents
- Retirement Plan Options for the Self-Employed | US News & World Reports
- Saving for Retirement: Investing in a Roth IRA When You’re Self-Employed | Careful Cents
- Why Your Retirement Needs Tax Diversification | Cash Money Life
Whether this is a problem you are currently facing or just something that has been weighing on your mind, feel free to contact me via phone or email so we can discuss your situation, goals, and solutions.
I built my first career in management consulting and have spent the last 20+ years putting my passion and skills to use in community and economic development. For the past seven years, I have provided business advice to hundreds of start-ups and small businesses.