Tax planning is an important aspect of choosing investment options, especially if one has plans to save up for their retirement. Tax-deferred and tax-exempt accounts are two of the most popular investment tools that allow people to minimize their tax bills. Kavan Choksi points out that both these types of account does reduce the sum of lifetime tax expenses an investor has to incur, and hence provides them with an incentive to start saving for retirement from a young age. However, there is a certain distinctive difference between these two types of accounts that come up just when the tax advantages kick in.
Kavan Choksi talks about tax-deferred and tax-exempt accounts
Tax-deferred accounts allow people to realize immediate tax deductions up to the full amount of their contribution. The money in their account shall grow undiminished by taxes, and future withdrawals from the account would be taxed at the ordinary income rate of the investor. Tax-exempt accounts, on the other hand, offer future tax benefits rather than tax breaks on contributions. Withdrawals at retirement are not subject to taxes in such investments. As contributions to the account are made with after-tax dollars, meaning that the investors fund this account with the money on which they have already paid taxes, there would be no kind of immediate tax advantage. The key advantage of the tax-exempt structure is that investment returns grow and can be withdrawn wholly tax free.
Investors can achieve major benefits by simply shifting the period when they pay taxes. Traditional IRAs and 401(k) plans are the most common types of tax-deferred retirement accounts in the United States. Taking part in a workplace plan and the sum of money they earn can also cut down the deductibility of some of the traditional IRA contributions of an investor. The immediate benefit of choosing to pay less tax in the current year offers a strong incentive for a number of individuals to fund tax-deferred accounts. As per typical investor thinking, the immediate tax advantage offered by current contributions usually outweighs the negative tax implications of future withdrawals. When a person retires, they are likely to generate less taxable income and thereby find themselves in a lower tax bracket. Usually, high earners are recommended by financial advisers to maximize their tax-deferred accounts in order to reduce their current tax burden. In the opinion of Kavan Choksi by getting an immediate tax advantage, investors are able to put more money into their accounts.
When it comes to tax-exempt accounts, the most popular options in the United States are the Roth IRA and Roth 401(k). There are many investors who ignore tax-exempt accounts as their tax benefits can occur as far as four decades into the future. These accounts, however, are perfect for youngsters who have just started to work. During the early stages of life, the taxable income and the corresponding tax bracket of investors are usually low but are likely to increase in the future. By choosing to open and contribute to a tax-exempt account on a regular basis, investors can access their funds, and enjoy the capital growth of their investments, without any tax concerns. As the withdrawals would be tax-free, taking out the money during retirement will not push investors into a higher tax bracket.