Unraveling Tax Jargon: Making Sense of Tax-Exempt, Tax-Deferred, and Tax-Deductible
By: Prachi Patke, CFA
Tax planning is an important context whether you are planning for retirement, a specific goal (think wedding planning, or your child’s education) or simply planning to optimize your excess funds. It is common for people to continue saving or deferring taxes for many years only to face a huge tax bill when they start withdrawals. There is no escaping the tax man, it is just a matter of optimizing when you pay up. The goal is to grow your assets while MINIMIZING the tax bill.
When you are considering various saving and investing instruments, some common terms you are likely to come across are pre-tax, after-tax, tax-exempt, tax-deferred, and tax-deductible. Let us demystify these terms today.
To explain these three concepts let us take a made-up numbers example. Let us say, your gross income is $100 but because you are subject to a tax rate of 30%. So today, your tax bill is $30 ($100*30), and your paycheck comes up to $70.
Pre-tax
Definition: Dollars you have not paid taxes on.
So, in our example, $100 is your pre-tax income. Similarly, when you contribute $20 to your 401(k) using pre-tax dollars, your remaining pre-tax income of $80 would be used to calculate your tax bill. What happens to this $20 in your 401(k)? Read on to find out.
Investment accounts like IRAs set limits on the maximum pre-tax investments you can make each year. It is a good idea to maximize the use of your pre-tax dollars before you start investing your after-tax dollars.
After-tax
Definition: The money that you have already paid taxes on.
So, in our example, after you invested $20 in a 401(k), you owe taxes on the remaining $80. Your tax bill would be $24 (given our assumption that you are in the 30% tax bracket: $80*30%) and the remaining $56 ($80-$24) is your after-tax income. Whether you choose to spend this on a massive Taco Bell order or invest in a tax-exempt account, remember, you will be using your after-tax dollars for these expenses / investments.
Tax-exempt (tax-free)
Definition: Accounts where your money can grow tax-free.
Some accounts like the Roth IRA allow you to grow your investments tax-free. Another way of putting it is that when you take qualified withdrawals from these accounts (adhering to certain criteria like investment horizon, age, income level, etc.), you will not pay taxes on these withdrawals. Your money grows at a faster rate when it is tax-free.
Why invest anywhere else, you ask? Well, for one, only those with income below a certain level are eligible to invest in Roth IRAs and there are limits on the maximum amount you can invest each year. You can read more about your eligibility and other conditions around investing in Roth IRAs. Here’s a resource to get you started. Here’s another article comparing the different types of IRAs.
Some examples of tax-exempt instruments are:
Roth IRA: Contributions are made with after-tax dollars, but withdrawals in retirement are tax-free.
Municipal bonds: Often provide interest income that is exempt from federal income tax, and sometimes state and local taxes as well.
Tax-deferred
Definition: An account that allows you to delay (defer) paying taxes.
In these types of accounts, you will owe taxes on your investment at a later time, i.e., when you make a withdrawal. So, with our example, the $20 that you invested in your tax-deferred 401(k) grows to approximately $152 in 30 years, assuming a pre-tax rate of 7%. However, in a taxable account with the same initial investment and assuming a 30% tax rate on the interest, the investment would grow to about $58 over the same period.
If you are a high earner today, chances are that when you retire in 30 years, you will find yourself in a lower tax bracket than you are today. In this case, it makes sense to maximize tax-deferred investments and minimize your tax bill today so that you generate tax in a lower tax bracket in the future.
Some examples of tax-deferred investment accounts are:
401(k) plans: Contributions are made with pre-tax dollars, and taxes are paid when the money is withdrawn in retirement.
Traditional IRAs: Contributions may also be tax-deductible, and the investments grow tax-deferred until retirement.
Tax-deductible
Definition: Certain expenses or contributions that can be subtracted from gross income, reducing the amount of tax owed today.
Tax-deductible expenses are those you can deduct from your total income before taxes are calculated, effectively lowering the amount of money you're taxed on. If you use your after-tax income for these expenses that are deemed tax-deductible, you may be eligible to get a refund. E.g., We had $56 in after-tax dollars. If you spent $26 on a Taco Bell order and invested the donated $30 to a qualified charity, then you would get a tax refund of $9 ($30*30% tax rate). Or if you elect to invest your pre-tax dollars, say $20 from your $100 of income, you can lower your tax bill because the tax is calculated off the remaining $80, instead of the whole $100 of your income.
Some examples of such accounts are:
Health Savings Account (HSA): Contributions are tax-deductible, and the money can be used for qualifying medical expenses tax-free.
Charitable donations: When you contribute to a qualified charitable organization, these donations are tax-deductible. For example, if you earn a $100 gross income and donate $30 of this to qualified charity, your taxable income could be reduced to $70. That means, your tax bill would be $21 ($70*30%) vs $30 ($100*30%) – sure, you spent $30 but you saved $9 in taxes! Of course, it is important to ensure that the charity is recognized by the IRS and to keep all receipts and documentation of your donations for tax filing purposes.
In conclusion, understanding the different tax implications of various investment accounts is crucial for effective financial planning. By strategically choosing between tax-deferred, tax-exempt, and tax-deductible investments, you can optimize your tax situation and enhance the growth of your assets over time.
Key Takeaways
Pre-tax investments reduce your taxable income at the time of contribution, leading to immediate tax savings.
After-tax contributions refer to the money you have left after paying taxes, which invest in tax-exempt or tax-deductible accounts, providing future financial benefits or immediate tax deductions.
Tax-exempt accounts like Roth IRAs allow your investments to grow tax-free, offering tax savings on potential gains.
Tax-deferred investments defer taxes until withdrawal, potentially allowing you to pay taxes in a lower bracket upon retirement.
Tax-deductible contributions can directly reduce your taxable income, thus lowering your current tax bill.
This article is for educational purposes only and is not intended to provide tax advice. The information contained herein is meant to explain certain financial and tax-related terms and concepts. Individuals should consult with financial advisors, tax professionals, or other personal consultants to obtain advice tailored to their specific situation and to make informed decisions about their financial planning and tax strategies.
