When it comes to comprehensive retirement planning, tax planning will always be a key component. When you are living off of a fixed income, as most are in their retirement years, the negative impacts of unanticipated taxes can be disastrous.
While no one knows exactly what the U.S. tax code will look like in a few years—or a few decades—a tax-free retirement account is the only way to avoid the tax problem in retirement entirely.
If it sounds too good to be true, it isn't. But there are limits and rules that govern how tax-free accounts work. Learn more about how they work, the benefits, and the potential downsides.
The Definition of Tax-Free
An account is considered tax-free if there is no federal or state tax due on income earned in the account both when the income is earned and when it is distributed or withdrawn.
It is through these types of accounts that money can be invested and grow without owing future taxes on that growth, even when you withdraw the funds to spend.
Examples of Tax-Free Accounts
There is only one type of tax-free retirement account: Roth IRAs and Roth 401(k) plans. Under defined withdrawal rules and annual income and contribution limits, after-tax money invested in a Roth IRA or a Roth 401(k) is allowed to grow tax-free and remains tax-free when withdrawn in retirement.
There is no other such tax-free retirement savings vehicle. Because this is such a valuable tool for retirement planners but not for the IRS—as it loses the opportunity to tax what could become a substantial account value—there are strict rules governing how Roth IRAs can be used to remain tax-free.
Many people mistakenly also call traditional IRAs tax-free accounts. While it is true that the money invested in a traditional IRA is allowed to grow free from taxes, the account is actually a tax-deferred account, meaning that the taxes are only delayed.
In a traditional IRA, withdrawals are subject to income taxes. Because of the required minimum distribution (RMD) rules, by the time the account owner turns 70 1/2, withdrawals must be made and thus taxed.
There are many more investment vehicles that offer this tax-deferral benefit over a completely tax-free benefit. For instance, in addition to traditional IRAs, annuities and the cash surrender value of whole life insurance policies also operate as tax-deferred accounts.
With a tax-deferred account, taxes are due at the time of distribution. With a tax-free account, no taxes are due as long as the rules are followed.
Tax-Free vs. Tax-Exempt Accounts
The primary difference between tax-free accounts and tax-exempt accounts is that individuals can't establish tax-exempt accounts in the U.S.
However, individuals may invest in certain types of bonds—like municipal bonds—that pay tax-exempt interest. Typically, such interest is only exempt from federal tax unless it meets some other criteria to be exempt from state and local taxes as well.
All investments have the potential to pay income, increase in value, or both. Income from those investments comes from two primary sources: interest and dividends.
If an investment is held in a taxable account, the income is added to the owner's taxable income for the year and results in a higher tax liability.
Any sales of assets held in a taxable account that are sold for more than what was invested will also result in increased income and subsequent income tax. By contrast, no tax would be due if the same investments were held in a tax-free account.
Tax Deductions for Contributions to Tax-Free Accounts
In general, you will not get tax deductions for these contributions. The benefit of a tax-free account is tax-free growth.
The primary trade-off for that benefit—aside from the strict rules that govern tax-free accounts like Roth IRAs—is that you do not get a deduction for the initial contribution to the plan and that contribution must be made with after-tax money.
However, there is one type of account that may also be used during retirement that offers upfront tax benefits and tax-free growth of earnings: the Health Savings Account, or HSA.
With an HSA, you receive an income tax deduction when you contribute money, but when you use the money in your HSA for medical expenses and qualified health insurance premiums, these distributions come out tax-free.