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What is the difference between tax-exempt and tax-deferred?

On Behalf of | May 10, 2022 | Wills

When developing your retirement plan, tax-deferred and tax-exempt retirement savings accounts are standard instruments to ensure you have enough money to live on in New York after you stop working. How are they different, and which one should you use?

Tax-deferred accounts

Most people are familiar with tax-deferred accounts for tax planning purposes. These are traditional IRAs and 401(k) plans. Placing money into these accounts allows taxpayers to receive immediate benefits as they money you put in annually will not be considered income on your tax filings. When you withdraw the money years ahead, the funds will be considered ordinary income. The ability to immediately reduce tax payments is a big draw for many individuals.

Tax-exempt accounts

The most common tax-exempt accounts in the United States are Roth IRAs and Roth 401(k) plans. These accounts don’t deliver tax perks when you contribute them, but you get the benefits when you withdraw the money as the fund plus all the earnings will be tax-free. In contrast the money earned in a regular investment account will incur taxes when you withdraw the money. Thus, when you take the money out in retirement, you won’t end up in a higher tax bracket.

Which type of investment is right for me?

A sound estate planning strategy will usually have a combination of tax-deferred and tax-exempt accounts. If you are younger and earning a substantial income, putting as much money into annual tax-deferred accounts may substantially reduce you current liability. However, at the same time, you should not ignore the potential benefits that Roth accounts will have.

Consider adding tax-deferred and tax-exempt accounts to your estate plan. You can also explore various trusts that will also provide benefits and income during your retirement years.

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