Wednesday, January 21, 2009

Choosing Between Taxable and Tax Deferred Saving Accounts

Whether to use a tax deferred or taxable savings account isn't a clear decision. There are advantages and disadvantages for both types of accounts. In the table below, I've summarized my view of the tax treatment for tax deferred and taxable saving accounts. Green signifies what I consider an advantage and red indicates what I consider a disadvantage of the account.

Tax Treatment

Tax Deferred


ContributionReduces taxable income in current year, except for Roth contributionsAfter tax money
EarningsGrows tax free and is not taxed until withdrawalTaxable each year as earnings occurs
Capital GainsOrdinary income tax rate at withdrawal, except for Roth and college saving accounts.Lower tax rate
DividendsOrdinary income tax rate, except for Roth and college saving accounts.Lower tax rate
WithdrawalRetirement accounts are taxed as ordinary income with penalty for withdrawals prior to 59 1/2. College savings account withdrawals are tax free when used for qualified education expenses and taxable otherwise.

No taxes on principal and can be withdrawn anytime and used for any reason

InheritanceTaxed as ordinary incomeCost basis steps up
Key - Green = advantage ; Red = disadvantage

To me, the best type account will depend on the financial situation of the individual saver and the expected timing of needing the money. Deferring taxes or avoiding taxes is an attractive option for those in higher tax brackets. However, the benefit does come with restrictions, which, if not met, can be costly to the saver. Taxable accounts offer the greatest flexibility, since the money can be accessed anytime for any reason.

From our experience, we found it best to put money in tax deferred accounts that we were very sure we didn't need until retirement. If we thought we might need the money in the next five years (e.g. emergency fund, car purchase, down payment for house, etc.) we put money in a taxable savings account.

For more on The Practice of Personal Finance, check back every Wednesday for a new segment.

This is not financial, tax or saving advice. Please consult a professional advisor.

Copyright © 2009 Achievement Catalyst, LLC

1 comment:

Manshu said...

Makes sense to me. I would lean a little towards paying taxes as late as I can, but that is just me.