Tax Deferred Earnings vs. Taxable

by Cynthia Myers

Tax deferred earnings grow without being taxed until you're ready to use the money at some future date, at which time you pay tax on the earning, thus, the tax is deferred. You pay taxes on taxable earnings in the year the money is earned. When you're ready to use the money the tax has already been paid, so you don't have to worry about it. Roth IRAs and Roth 401(k)s are taxed when you deposit the money in the account, while traditional IRAs and Roth IRAs use tax deferred funds. Saving for retirement may involve both tax deferred and taxable earnings.


Tax deferred earnings allow you to reduce your income tax bill now, during your working years. You don't have to pay tax on the money until you withdraw it in the future, at which time you will probably be retired and may fall into a lower tax bracket. Roth accounts offer the advantage of getting taxes out of the way now. You don't pay taxes on the withdrawals you make in the future, and you don't pay taxes on the money the account has earned through interest and dividends. The younger you are when you start saving for retirement, the larger the advantage of a Roth account.


The IRS limits the amount of money you can deposit in a Roth account each year to $5,000 if you're under 50 or $6,000 if you're 50 or older. If you want to save more money for retirement, you may need more than one kind of account. If you're close to retirement age your money doesn't have a lot of time to grow, so a regular, tax-deferred retirement account may be a better financial choice for you than a taxable Roth account. Depending on your financial situation you may prefer to take the tax deduction for depositing money in a tax-deferred account than to have to pay taxes on money you save in a Roth.


If you're young and have many working years ahead of you, can afford to forgo the tax deduction allowed for putting funds in a tax-deferred IRA, a Roth account could yield a lot of extra money come retirement time. If you need money to pay for education or a first home in the years ahead, you can withdraw funds from a Roth account without penalty. If you're closer to retirement or need to take advantage of tax cuts, investing in a tax-deferred savings plan might make more sense than you. If you die before you use your retirement savings, your heirs have to pay taxes on any money from tax-deferred accounts, but won't owe taxes on Roth accounts.


Whatever choice you make, you'll need to report both tax-deferred and taxable investments on your income tax form. You'll receive a 1099 from each investment account. You're also required to report any withdrawals from your funds and to pay any taxes owed.

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