What is the Purpose of Tax Deferred Retirement Accounts?

Written by: Karl Rainer

When designing a long-term savings plan, you will generally want to start by utilizing any tax-advantaged accounts you have available. Today we’ll dive into what is the purpose of tax deferred retirement accounts.

Before taking a deeper dive on the different options that you have available, it is important to understand that not all tax-advantaged accounts are the same. If we were looking to group these options, the first distinction would likely be whether an account is tax-deferred or tax-exempt.

While there are tax-deferred accounts that are not formal retirement plans (e.g., annuities, certain forms of life insurance, I Bonds, etc.), this article is going to be focusing specifically on retirement plans.

The most common types of tax-deferred retirement plans that you may run into include 401k/403b plans, Traditional IRAs and SEP IRAs.

Is an IRA the same as a 401k or 403b? No. While pre-tax IRAs (basically any IRA that is not a Roth IRA) and 401k/403b plans enjoy the same general tax benefits, the “I” in IRA stands for “individual”, so these plans are generally set up on your own and not through an employer like 401k/403b plans.

Benefits of Tax-Deferred Retirement Options

With any of these tax-deferred retirement options, you contribute with pre-tax dollars, meaning you get a tax deduction when you contribute.

For example, if your income was $100k/year and throughout that year, you contributed $10k to your employer’s 401k or 403b on a pre-tax basis, come tax time, the IRS would only tax you as if you had earned $90k/yr.

If you were in a 25% tax bracket, you would be saving roughly $2,500/year in taxes you would have otherwise owed, so not only are you saving for your future self, you are also enjoying a valuable tax benefit today!

From there, you can invest that $10k however you’d like (within the confines of the funds you have available for that plan), and any investment earnings are tax-deferred. Essentially, this means that you do not have to pay capital gains taxes when you sell a security and “realize” a gain.

This also means you don’t need to worry about tax-loss harvesting in tax-deferred accounts.

How does this Differ from Non-Retirement/Taxable Accounts?

For example, if you had instead used that same $10k to invest in a stock within a non-retirement brokerage account, if you later sold that stock for $15k, then that $5k of appreciation would be subject to capital gains tax.

There are two types of capital gains taxes; short-term (meaning you held that particular security for 1 year or less) and long-term (securities held for greater than 1 year). Short-term capital gains are taxed at the same tax rate as ordinary income (i.e., income earned through your job), whereas long-term capital gains have historically been around half that rate (as of 2021, for most of you, that rate is anywhere from 15-20%).

Those dollars that you had to use to pay the capital gains tax are essentially the opportunity cost because within a tax-deferred account, no taxes would have been owed in this situation, ultimately allowing for faster compounding growth.

That all sounds fantastic, but what is the catch? Well, the main downside to tax-deferred retirement plans is that when you get to retirement, qualified distributions would be taxable as ordinary income. As the name implies, you were just deferring those taxes to a future date.

Tax Exempt Retirement Plans

On the flip side, we have “tax exempt” retirement plans, which include Roth IRAs or Roth 401k/403b plans. With these accounts, there is no upfront tax benefit when you contribute.

Using the same example as above where you have a $100k/year salary, if you instead contributed that $10k to your employers Roth 401k, then come tax time, you are still taxed on all $100k of earnings.

Like their tax-deferred counterparts, investment earnings are still not taxed when you realize a gain by selling, however, the primary benefit is that when you get to retirement age (currently 59.5), you can take distributions from your tax-exempt retirement account without paying any income tax.

Essentially, the IRS just wants to tax your money once; either when it is going in (tax-exempt retirement plans) or when you are taking distributions (tax-deferred retirement accounts). That begs a question we advisors are frequently asked, “which one is better?” Well, it depends entirely on your individual circumstances.

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When a Tax-Exempt Retirement Plan Could Make Sense

As it relates to medical professionals, generally speaking, those who are still in-training should target tax-exempt retirement plans (e.g., Roth IRAs or Roth 401k/403b plans).

If a resident/fellow physician were contributing to a tax-deferred retirement plan (above and beyond whatever is needed to get any employer matching contributions), they are essentially taking a tax deduction in what is likely to be the lowest tax bracket they will ever be in, to then pay taxes in retirement, when they are likely to be in a higher tax bracket. That doesn’t make any sense.

While most medical professionals have lower expenses in retirement than their peak income-earning years due to not having to save or pay off debt, many would still prefer a lifestyle closer to those peak years than that of a resident/fellow. By forgoing any upfront benefits and instead contributing to a tax-exempt plan, you are paying the tax while still in a low bracket.

When a Tax-Deferred Retirement Plan Could Make Sense

For those who are more or less at their expected peak incomes, you would generally want to contribute to tax-deferred retirement plans. When your income is at its peak, tax deductions become even more valuable.

With that said, in this situation, due to annual contribution limits, you are likely not going to be able to save everything into tax-deferred accounts. There are also benefits to being diversified from a tax perspective.

As of 2022, the most you can contribute to a 401k or 403b plan is $20,500 ($27,000 if you age 50 or over). A good rule-of-thumb for long-term savings is that you should target trying to save at least 20% of your gross income each year, so depending on your income, maxing out your 401k or 403b alone isn’t going to be sufficient.

Should I Have a 401k and a Roth IRA?

As long as you are eligible, yes, you can have both accounts. One important note is that Roth IRAs have income restrictions on who is eligible to contribute. Some get around this by making “backdoor” Roth IRA contributions, however, this strategy may only be allowed for certain individuals moving forward.

The benefit to having both tax-deferred and tax-exempt retirement plans is that you will have more control over the amount of tax you are paying each year in retirement.

If you have both a 401k and a Roth IRA, then in retirement, in years when taxes are relatively high, you can pull from your Roth IRA. On the flip side, in those years where taxes may be lower, you’d want to take distributions from your tax-deferred accounts. With these accounts, you know you’ll have to pay the tax at some point regardless, so you may as well do it when taxes are relatively low.

How Many Retirement Accounts Should I Have?

While there is no limit to how many retirement plans you can actually have, you would generally want to keep as few as possible for simplicity. As an advisor, I care about how my client’s portfolios are allocated in the aggregate. It doesn’t really matter to me if one 401k is a little under-exposed to international equity, another is over-exposed to small-cap equity, etc., so long as that when we look at everything together, we are in our target allocation.

Reducing the number of accounts makes this a lot easier to manage. If you have a few old retirement plans laying around, here is a blog post from a few months ago explaining what you can do with your old retirement plans. Generally, when you get to retirement, it would be ideal to just have two “buckets”; one for all your pre-tax or tax-deferred accounts and another for all your post-tax or tax-exempt accounts).

In Summary

What is the purpose of tax-advantaged retirement plans? Primarily, to help you accumulate wealth, while minimizing your tax exposure along the way. Managing taxes as efficiently as possible allows your investments more time to reap the benefits of compound growth. Every situation is different, so make sure to consult with a financial professional to help figure what types of accounts are most appropriate given your individual circumstances.

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