A tax-free retirement account (TFRA) can help you reliably reach your financial goals by providing you with tax-advantaged investment gains and retirement income. These accounts are often a critical pillar of a diversified retirement strategy.
This article will explore what a TFRA account is, the benefits and disadvantages of these accounts, and what you should consider before opening one.
To determine whether a TFRA account is right for you, please contact the ARQ Wealth team by calling (480) 214-9572. ARQ Wealth’s financial advisors can provide personalized advice that will help you reach your financial goals while minimizing your tax burden.
What is a Tax-Free Retirement Account (TFRA)?
A tax-free retirement account refers to any retirement savings plan where your withdrawals are not subject to income taxes (as long as you meet the requirements set by the IRS).
Tax-free retirement accounts are commonly confused with “tax-deferred” retirement accounts, and it’s crucial to understand this difference.
With that in mind, let’s explore the differences between tax-free and tax-deferred accounts.
Tax-Free vs Tax-Deferred
A tax-free (or tax-exempt) retirement plan is a plan that you contribute to with after-tax dollars. A tax-deferred retirement plan is a plan that you contribute to with pre-tax dollars.
The phrase “tax-free retirement plan” can be slightly misleading because you still pay taxes. You just pay taxes on your initial contributions instead of your withdrawals.
For this reason, these plans are often referred to as tax-exempt plans.
There are two main types of tax-free (or tax-exempt) plans:
Tax-free retirement accounts: Roth IRAs and Roth 401(k)s
- You do pay taxes when you put money in
- You don’t pay taxes when you take money out
Tax-deferred retirement accounts: Traditional IRAs and 401(k)s
- You don’t pay taxes when you put money in
- You do pay taxes when you take money out
The difference between these two retirement plans may sound insignificant. After all, you’ll have to pay your tax liability either way, so does it matter when you pay?
Being strategic about when you pay taxes can dramatically affect the total size of your retirement nest egg. Let’s look at an example of opening a Roth IRA compared to a traditional IRA to get a better idea of how this works.
Traditional IRA vs Roth IRA Example
John is 30 years old, makes $80,000 a year, and wants to start saving for retirement. He is trying to decide between opening a Roth IRA and a traditional IRA and weighs the benefits of each account.
If John opens a traditional IRA and contributes $6,500/year, then he’ll be able to deduct these contributions from his income. This would lower his taxable income from $80,000 to $73,500, which would provide immediate tax savings. However, John will have to pay federal income taxes on his withdrawals when he reaches age 65.
If John opens a Roth IRA and contributes $6,500/year, then he will have to pay taxes on his full $80,000 income today. However, he will be able to withdraw his money tax-free (including his investment gains) when he reaches age 65.
The bottom line: It generally makes the most sense to open a tax-deferred account when you are a high-income earner and expect to have a lower income in retirement.
This can allow you to take advantage of tax savings now (while your income is higher), and you stand to save more money on taxes.
However, it makes sense to open a tax-free retirement account when you expect your income to be higher in retirement. You can pay your tax now and then enjoy tax-free withdrawals when you retire.
This is a general example, and the best option for you will vary based on several factors.
Please contact the ARQ Wealth team to learn whether a TFRA retirement account is right for you.
How Do TFRAs Work?
Tax-free retirement accounts work by allowing you to invest money that you’ve already paid taxes on so that this money can grow tax-free and help you fund your retirement. When it’s time to retire, you can make withdrawals from most TFRAs tax-free if you are 59 ½ and have had the account for at least five years.
The biggest benefit of a TFRA is that it allows you to save significant money in taxes. If you were to use a regular investment account for your retirement savings, your gains would be subject to long-term capital gains tax, drastically reducing the size of your nest egg.
Depending on your income, capital gains tax can be as high as 20%.
This means that if you saved up a nest egg of $5 million through a regular investment account, you could be on the hook to pay as much as $1 million in capital gains tax.
A TFRA eliminates this tax burden and helps you maximize your retirement savings.
Should You Consider a TFRA?
A tax-free retirement plan (when referring to all retirement plans that delay your tax burden) can be a valuable addition to your retirement plan. Here are a few of the main things to consider when deciding whether or not to open one:
Will your income be higher in the future?
If you anticipate having a higher income during retirement, then it makes sense to open a TFRA instead of a tax-deferred account. Most people’s earning potential increases over time, so it usually makes sense to open a TFRA, contribute after-tax dollars, and enjoy a greater tax-free retirement income.
However, this isn’t always the case.
For example, a high-earning young professional might be better off opening a tax-deferred retirement account and enjoying the tax savings now.
Do you anticipate a strong market performance?
Remember that you do not have to pay taxes on investment gains in a TFRA. If you anticipate a strong market performance in the coming years, then you’ll likely want to open a TFRA so that you can enjoy the benefits of asset appreciation without worrying about your tax bill.
If you’re close to retirement age or anticipate a less-than-ideal stock market performance in the coming years, you might be better off pursuing other asset classes.
What is your investment horizon?
Many tax-free retirement accounts do not require you to start making withdrawals during your retirement, which can also play a role in determining which account is best for you.
If you do not plan on accessing your retirement funds until deep into your golden years, then it makes much more sense to open a TFRA, which offers this flexibility. The same is true if you’re planning to leave your assets to an heir after you pass away.
Do you have excess capital to invest?
If you’re a high earner, there’s a good chance you have excess cash to invest. In this case, opening multiple accounts is likely a good idea.
For example, you could open a TFRA like a Roth IRA and contribute the annual maximum.
Then, you could open a tax-deferred account and continue to make contributions. You could even go one step further and open an individual brokerage account and use strategies like tax-loss harvesting to offset your capital gains as much as possible.
Choosing this strategy can help you reap the rewards of both types of plans.
The Bottom Line of Tax-Free Retirement Accounts
Remember, with a tax-free retirement account (like a Roth IRA or Roth 401(k)), you will pay taxes when you make contributions but won’t pay taxes when you make withdrawals.
With a tax-deferred account (like a traditional IRA or 401(k)), you won’t pay taxes when you make contributions, but will pay taxes when you make withdrawals.
Be sure to contact the ARQ Wealth team by calling (480) 214-9572 to find out what is best for you. ARQ Wealth’s financial advisors are retirement planning professionals and can recommend the best retirement strategies that fit your income, investment horizon, and goals.