Tax deferred vs tax free

What is tax-deferred growth?

Tax-deferred growth is an extremely simple concept that can be leveraged by the average person to generate incredible wealth.  In a nutshell, it just means you pay taxes later on the money that you’re currently growing in your account.  Why pay money to the IRS now when you can defer it to later?  Generally speaking, it’s almost always advantageous to hold onto your money for as long as possible, earning interest along the way, rather than giving that money to the IRS and allowing them to earn interest on it.

The most common way for the average person to delay paying taxes on their investments is through a qualified retirement account.  This would include a Traditional IRA, 401k, 403b, most pensions and annuities.

Why pay taxes later?

The IRS will of course always get their cut of your income, and the same goes for income generated by your investments (capital gains, dividends etc.).  But if you have a qualified investment plan like a 401k or IRA, taxes on that income doesn’t need to be paid each year (unless it’s a Roth IRA/401k).  Instead, your investments will grow year after year, and will only be taxed when you withdraw them during retirement.  For example, if you have a “play account” where maybe you trade stocks with a brokerage, and you make $10,000 on those trades, you will have to pay taxes on those gains at the end of the year.  If you held them for less than 1 year, it’ll be taxed as normal income, if its more than 1 year it will be taxed at the “long-term capital gains rate”, which is around 15% for most people.  Within your IRA or 401k, that $10,000 can be reinvested back to purchase more shares, and you won’t pay taxes on it until retirement.

Should I get tax-free growth instead?

While tax-deferred growth can be a fantastic tool to build wealth, for many people (especially younger people), using an account that generates tax-free growth like a Roth IRA or 401k can be even better.  In a Roth account, your contributions are not deductible like they are in a tax-deferred account.  In other words, you’ll pay income tax on that money each tax season.  However, when you withdraw the money in retirement, you will not have to pay any taxes on those withdrawals.  In other words, the difference between tax -deferred and tax-free growth is that in the latter you’re not paying taxes at all, but you can’t claim a deduction each year on your taxes. Generally, if you expect to be in a higher tax bracket later in your life, a Roth is a better deal.  The drawback is that direct Roth contributions are only available below certain Adjusted Growth Income (AGI) levels (see table below).

If you’re a high earner and can’t contribute to a Roth IRA directly, there is still the option of doing a “backdoor Roth”, which involves contributing to a traditional IRA, but then doing a conversion to a Roth.  This means you’ll pay taxes on that amount, but after that your investments will grow completely tax-free.  This can be a tricky process, with the “pro-rata” rule causing confusion amongst many investors.  If you’re looking to set-up a backdoor conversion in Oklahoma, please feel free to contact us!

2019 IRA contribution limits

Roth IRA Contribution Limit

$6,000

$5,500

Roth IRA Contribution Limit if 50 or over

$7,000

$6,500

Traditional IRA Contribution Limit

$6,000

$5,500

Traditional IRA Contribution Limit if 50 or over

$7,000

$6,500

Roth IRA Income Limits (for single filers)

Phase-out starts at $122,000; ineligible at $137,000

Phase-out starts at $120,000; ineligible at $135,000

Roth IRA Income Limits (for married filing jointly and qualifying widow(er) filers)

Phase-out starts at $193,000; ineligible at $203,000

Phase-out starts at $189,000; ineligible at $199,000