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Understanding Tax-Deferred Retirement Accounts

Tax-deferred retirement accounts offer a strategic way to save for the future while reducing your taxable income today. These accounts allow your funds to grow tax-free, with taxes only being applied when you make withdrawals. While they come with several advantages, there are also some drawbacks to consider. Let’s explore how these accounts work to help you determine if they are the right choice for you.

What Is a Tax-Deferred Retirement Account?

Popular tax-deferred retirement accounts include 401(k)s and traditional individual retirement accounts (IRAs). Both types of accounts provide a tax-friendly approach to long-term saving by allowing for tax-deductible contributions. Your balance remains sheltered from taxes until you withdraw funds, at which point your withdrawals will be taxed as ordinary income based on your tax bracket.

This differs from other investment accounts, such as brokerage accounts, where you may be taxed on investment gains during the year they are realized. While taxable accounts offer greater flexibility with no contribution limits, early withdrawal penalties, or required minimum distributions (RMDs), tax-deferred accounts provide specific tax advantages.

Pros and Cons of Tax-Deferred Retirement Accounts

Tax-deferred retirement accounts come with a variety of benefits, but there are also some drawbacks to be aware of.

Pros

• Tax-deductible contributions: You can reduce your taxable income by subtracting your contributions, potentially lowering your tax liability and moving you into a lower tax bracket.
• Tax-free growth: Dividends, interest, and capital gains are not taxed until you withdraw money from the account.
• Potential employer match: Many employers match contributions to 401(k) accounts, with the average match being 4.8%, according to Fidelity Investments. This can significantly boost your savings over time.

Cons

• Contribution limits: In 2023, you can contribute up to $22,500 to a 401(k) and $6,500 to an IRA. Additional catch-up contributions are available for those aged 50 and older. Health savings accounts (HSAs) have their own contribution limits.
• Early withdrawal penalties: Withdrawing funds from a 401(k) or traditional IRA before age 59½ usually incurs a 10% penalty. For HSAs, non-qualified withdrawals before age 65 result in a 20% penalty.
• RMDs: Required minimum distributions must begin at age 73 for 401(k) and traditional IRA accounts, with a 25% penalty for non-compliance. HSAs are exempt from RMD rules.

Tax-Deferred vs. Tax-Exempt Retirement Accounts

Tax-deferred retirement plans delay taxes until withdrawals are made in retirement, whereas tax-exempt accounts, like Roth IRAs, are funded with after-tax dollars. Roth IRAs allow for tax- and penalty-free withdrawals of contributions at any time, provided the account has been open for at least five years. However, early withdrawals of earnings may incur penalties. Roth 401(k)s have different rules, but RMDs are not required.

3 Types of Tax-Deferred Accounts

Traditional 401(k)

This employer-sponsored retirement plan is typically funded through automatic payroll deductions. Many companies offer a 401(k) as an employee benefit, and self-employed individuals can access similar benefits with a solo 401(k).

Traditional IRA

Available through brokerage firms, traditional IRAs can be opened and funded without employer involvement. While contribution limits are lower compared to 401(k)s, they can still be a valuable addition to your retirement savings strategy.

HSA

Health savings accounts are designed for individuals with high-deductible health plans. Contributions are tax-deductible, and withdrawals for qualified medical expenses are tax- and penalty-free. In 2023, individuals can contribute up to $3,850, and families can contribute up to $7,750. After age 65, HSA funds can be used for any purpose, though non-qualified withdrawals will be taxed.

The Bottom Line

Tax-deferred retirement accounts offer significant tax benefits, including tax-deductible contributions and tax-free growth until withdrawal. However, early withdrawal penalties and required minimum distributions should be considered. As you plan for retirement, it’s also important to monitor your credit health. Free credit monitoring with Experian can alert you to changes in your credit report, helping you detect and address identity theft quickly.

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