Tax-Deferred vs. Tax-Exempt
If you have investments in a tax-deferred account, the earnings on those investments aren't taxed until you withdraw the money, Hardy said.
"This allows for all the gains to continue to earn interest, which has a compounding effect," he said. "If you compare the growth of an account that is tax-deferred to that which is not, you will notice that the tax-deferred account could have a value over 20-plus years of as much as 25 percent more."
IRAs and 401ks are tax-deferred accounts. Not only do you avoid paying taxes on the earnings in these accounts until you withdraw the money, but you also avoid paying taxes on the amount you contribute. Contributions to an IRA can be deducted when you file a tax return, and contributions to a 401k come out of a paycheck before taxes. For example, if you earned $100,000 and contributed 10 percent to your 401k pretax, then your reportable income would be $90,000, Hayes said.
A tax-exempt — or post-tax — account such as a Roth IRA or Roth 401k gives you the tax benefit when you withdraw the money. Contributions are made with after-tax dollars, so there's no upfront tax benefit. But withdrawals in retirement are tax-free. A tax-exempt account can be a better option if you expect your income-tax rate to be higher when you withdraw the money than when you contributed it, Hayes said.
Up Next: Roth Vs. Traditional IRA — Which Retirement Plan Is Better for You?