Many people are not aware of the difference between tax-deferred and tax-free account, but this has a huge effect over time and it is important to get educated on the topic.
A tax-deferred account is one that you feed with pre-tax dollars and that grows without taxes being paid on the accumulation. As long as you leave the gains and interest in the account untouched, taxes won't come due. Hence, tax-deferred. The taxation is postponed until you're ready to withdraw, and only then will you pay taxes on the accumulation.
But it's when you start to withdraw from the account in retired years that things get ugly. That's when a tax-deferred account morphs into what I call a "tax-infested" account.
Here's a simple example. You have a one-dollar tax-deferred account that grows to $100 through smart investment choices. The tax liabilityâthe infestationâgrows as your account grows, dollar by dollar, beginning with that first dollar. So that dollar with which you opened the account (but didn't report as income) eventually will be taxed. You started with one dollar but when you're ready to withdraw you'll pay taxes on $100.
Although the exact amount you'll pay depends on your tax bracket, it could reach as high as 35%, at current rates, and could go much higher if the government decides to finance its massive mountain of spending and debt by reaching deeper into the pockets of taxpayers. (If you're now nearing retirement, you probably recall that the top tax bracket was once over 90%. Where is it written that taxes can't go into that territory again?) The infestation thus accumulates along with your investment.
Thankfully, tax-free accounts aren't so tricky. It's as simple as this: Your account grows without taxation whether you withdraw the interest or notâforever! You'll never have to pay taxes on it.
Phil Cannella is a Master IRA advisor and founder of First Senior Financial Group in Pennsylvania.