As a business owner or investor, it’s essential to understand how different types of investment accounts impact your tax liability. When it comes to investment income, two common terms you’ll hear are "tax deferred" and "tax exempt." While both strategies offer tax advantages, they work in different ways and can significantly affect your long-term financial planning. Let’s break down the differences and when you might use each approach.
Tax Deferred Accounts
A tax-deferred account allows you to postpone paying taxes on income until you withdraw funds. Contributions to tax-deferred accounts are typically made pre-tax, which means they reduce your taxable income in the year you contribute. The funds in these accounts grow tax-free until they are withdrawn, usually during retirement. At that point, the withdrawals are taxed as ordinary income.
Examples of Tax-Deferred Accounts:
401(k): Many business owners and employees contribute to a 401(k) to save for retirement. The contributions are tax-deferred, meaning no tax is paid on that income until retirement withdrawals begin.
Traditional IRA: Similar to a 401(k), contributions to a Traditional IRA are tax-deferred. You don’t pay taxes on the investment income as it grows, but you will owe taxes on withdrawals in retirement.
The Benefit:
Tax deferral allows your investments to grow faster because the earnings compound without being reduced by taxes each year. The assumption is that you will be in a lower tax bracket during retirement when withdrawals are taxed, leading to overall tax savings.
Tax Exempt Income
Tax-exempt income is not subject to federal (and often state) taxes. This type of income is typically generated by certain municipal bonds or investments in Roth accounts, where the returns are never taxed, even when withdrawn.
Examples of Tax-Exempt Income:
Municipal Bonds: Interest income from municipal bonds (munis) is generally exempt from federal income taxes. If the bonds are issued in your state of residence, they might also be exempt from state taxes.
Roth IRA or Roth 401(k): Contributions to Roth accounts are made with after-tax dollars, but both the growth and withdrawals in retirement are tax-free, provided certain conditions are met.
The Benefit:
Tax-exempt income provides peace of mind because you never pay taxes on that income. This can be particularly valuable for high earners or those looking to reduce their taxable income in retirement.
Questions Comparing Tax-Deferred and Tax-Exempt
Tax-Deferred: You get an upfront tax break by deferring taxes on contributions and earnings until retirement. The earnings are eventually taxed as income when withdrawn.
Tax-Exempt: You don't get an upfront tax break (since contributions are made with after-tax dollars), but your investment income and withdrawals are tax-free forever.
Why You Generally Don't Want Tax-Exempt Investments in a Tax-Deferred Account
It might seem logical to put tax-exempt investments, like municipal bonds, in tax-deferred accounts such as a 401(k) or Traditional IRA. However, this strategy is usually not beneficial. Here’s why:
Double Tax Benefit Isn’t Allowed: Tax-exempt income, like interest from municipal bonds, is already free from federal income tax. Placing them in a tax-deferred account provides no additional tax benefit. In fact, it can negate the tax advantage since, when you eventually withdraw from a tax-deferred account, all withdrawals—including the income from tax-exempt investments—are taxed as ordinary income.
Maximize Growth with Tax-Deferred Accounts: Tax-deferred accounts are best used for investments that generate taxable income, like stocks and bonds, which can grow without being taxed annually. By putting high-growth, taxable investments into a tax-deferred account, you can delay paying taxes on gains and dividends until you withdraw the funds.
Questions
Understanding the difference between tax-deferred and tax-exempt investment strategies is essential for effective tax planning. Tax-deferred accounts, like 401(k)s and Traditional IRAs, offer the advantage of delaying taxes on your investment growth, while tax-exempt investments, such as municipal bonds and Roth IRAs, provide tax-free income. However, it’s important to use these tools wisely. Tax-exempt investments are best held in taxable accounts where their tax benefits can be fully realized, while tax-deferred accounts should be reserved for investments that will benefit from tax deferral over time.
With the right mix of both strategies, you can maximize your after-tax returns and ensure your investments are working as efficiently as possible for your future.
If you have any questions, please do not hesitate to contact TrueBlaze Advisors.
Read more articles from this series here:
Tax Credits vs. Tax Deductions: Understanding the Difference
Understanding Marginal Tax Brackets
Understanding Standard vs. Itemized Deductions
Understanding Use Tax: What it is and Why it Matters to Your Business