Tax-Deferred vs. Tax-Exempt Accounts: Key Differences and Benefits
Written by
Jacob Wade
Edited by
Emily Gadd
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If you’re investing for retirement, where you put your money matters. Retirement accounts offer tax incentives to help you save money on your tax bill and grow your investment accounts. But while tax-deferred accounts and tax-exempt accounts have some similarities, they are used for different purposes — and choosing one or the other can have big implications on your tax bill. Here’s everything you need to know:
What Are Tax-Deferred Accounts?
Tax-deferred accounts allow you to save on taxes now — deferring your tax bill until a later date. The two most popular tax-deferred retirement accounts are the 401(k) workplace retirement account and a traditional Individual Retirement Account (IRA).
When you contribute to a tax-deferred retirement account, the money you put in does not count as income. For example; If you earn $75,000 and contribute $7,000 to your IRA — your taxable income would only be $68,000.
Money invested inside a tax-deferred retirement account also does not generate any capital gains or income tax. The investments are allowed to grow tax-free until you start making withdrawals in retirement.
While tax-deferred accounts save on taxes now — you’ll need to pay taxes on withdrawals from these accounts in the future. Both 401(k) and IRA accounts allow you to start withdrawing funds penalty-free at age 59.5. When you withdraw funds from your tax-deferred accounts, the money you take out counts as ordinary income for tax purposes.
For example; If you earn $50,000 — but then withdraw another $5,000 from your tax-deferred retirement account–your taxable income would be $55,000.
What Are Tax-Exempt Accounts?
Tax-exempt accounts don’t give you a tax break when you contribute funds — but the money grows tax-free, and is completely tax-exempt when you start withdrawing funds in retirement. The two most popular tax-exempt accounts are the Roth 401(k) and Roth IRA.
When you contribute to a tax-exempt retirement account the money is “after-tax” — meaning you’ve already paid income taxes on these funds from your paycheck. For example; If you contribute $10,000 to your Roth 401(k) account, it will not reduce your taxable income.
Money invested inside a tax-exempt retirement account doesn’t incur any capital gains or income taxes from earnings. As long as the gains and earnings from your investments stay within the account — you don’t have to pay taxes on it.
You can also access the contributions to a Roth IRA account at any time — penalty and tax-free. This is because you’ve already paid income taxes on the contributions to a Roth IRA, so you can access the contributions at any time. You cannot — however — access the capital gains or dividends earned on your Roth IRA investments until age 59.5 without a tax penalty unless you have a qualified exception.
While tax-exempt accounts don’t save on taxes now — you can withdraw funds in retirement without paying taxes. For example; If you earn $50,000 — but then withdraw another $15,000 from your tax-exempt retirement account after age 59.5 — your taxable income would stay at just $50,000.
Key Differences Between Tax-Deferred and Tax-Exempt Accounts
Here’s how tax-deferred and tax-exempt retirement account compare:
| Tax-Deferred Accounts | Tax-Exempt Accounts | |
|---|---|---|
| Account types | – IRA, – 401(k) – SEP IRA – 403b |
– Roth IRA – Roth 401(k) |
| Tax treatment | – Lower taxable income in the year you contribute – Grows tax-free – Taxable as ordinary income in retirement |
– No tax benefit in the year you contribute – Grows tax-free – Withdrawals not taxable in retirement |
| Contribution limits (2025) | – IRA: $7,000 ($8,000 if age 50 or older) – 401(k): $23,500 ($31,000 if age 50 or older) |
– Roth IRA: $7,000 ($8,000 if age 50 or older) – Roth 401(k): $23,500 ($31,000 if age 50 or older) |
| Penalty-free withdrawals | – None until age 59.5 (unless you have a qualified exception) | – Contributions can be withdrawn at any time – Earnings can’t be withdrawn until age 59.5 (unless you have a qualified exception) |
Pros and Cons of Tax-Deferred Accounts
Tax-deferred accounts have a few advantages:
- Save on taxes now. When you contribute to a tax-deferred retirement account, it lowers your taxable income. This means you pay less in taxes in the year you contribute. This can be especially beneficial if you’re in a high tax bracket.
- Tax-free growth. When you invest in a tax=deferred account, the earnings and growth in the account are tax-free. You don’t have to pay capital gains taxes for any trades you make — and dividends and interest earned are also tax-free. You simply pay regular income taxes when you begin withdrawing funds in retirement.
- More money available to invest. When you save on taxes, this theoretically gives you more money to invest each year. This can help your accounts grow faster.
Pros and Cons of Tax-Exempt Accounts
Tax-exempt accounts have a leg-up in a few areas:
- Tax-free retirement income. Tax-exempt accounts don’t save on taxes now, but the growth is tax-free, and you can withdraw as much as you want in retirement without paying another penny in taxes. This can be a powerful way to lower your tax bill in retirement.
- Access contributions any time. When you contribute to a tax-exempt account, the funds have already been taxed when you earned the money. And with a Roth IRA, you can access your principal investment any time without penalty. This gives you more flexibility with your investments, and can act as a backup emergency fund if needed.
- Best for those in a low tax bracket. If you are in a lower tax bracket right now, it can make more sense to contribute to a tax-exempt account. You won’t pay much in income taxes anyway — and as your income grows into retirement, you can save a lot more in taxes when you access the funds later.
When to Use Tax-Deferred vs. Tax-Exempt Accounts
Choosing between a tax-exempt and tax-deferred investment account depending on your goals, priorities, tax rate, and future plans. Here’s a few scenarios when you’d choose one account over another:
Lower Tax Bracket
If you are in a lower tax bracket it can make sense to choose a tax-exempt account. The big benefit of tax-exempt accounts is to pay tax on your savings later, but you don’t get a tax deduction for contributions. With a low tax rate, this might make a big impact on your tax bill right now — but can drastically lower your tax burden in retirement.
High Tax Bracket
If you are in a high tax bracket, it could make more sense to invest in a tax-deferred retirement account. This allows you to lower your taxes now (while they are expensive) and save for the future. When you start withdrawing funds for retirement, you may have more control over your tax rates and can balance withdrawing from the tax-deferred account and other income sources.
Access to Funds
If you prefer more flexibility and access to your funds, investing in a Roth IRA allows you to access your contributions at any time without penalties or taxes. Because the Roth-IRA is a tax-exempt account, you’ve already paid income taxes before you contributed. This flexibility can come in handy as a backup emergency fund — or if you retire before age 59.5 and need access to your money to pay for living expenses.
The Bottom Line
Both tax-deferred and tax-exempt accounts encourage you to invest for retirement by giving you tax savings. Tax -deferred accounts make sense when you’re in a high tax bracket — as they will lower your tax bill in the year you contribute. Tax-exempt accounts can make sense when you anticipate a higher tax rate in retirement–and if you want more flexibility to access your money early. Overall, investing in any kind of tax-advantaged retirement account is a win.
FAQ
- What is the difference between tax-exempt and tax-deferred accounts?
- A tax-exempt investment account allows you to contribute "post-tax" money--money you've already paid income taxes on. But the investments in the tax-exempt account can be withdrawn tax-free in retirement. Contributing to a tax-deferred investment account lowers your taxable income now, but when you withdraw funds in retirement, you'll have to count that amount as income.
- Is 401k tax-deferred or tax-exempt?
- Your 401k account is typically a tax-deferred account (save on taxes now), but you may be able to open a Roth 401k account, which is tax-exempt.
- Is a Roth IRA tax-deferred or tax-exempt?
- A Roth IRA is a tax-exempt investment account. You contribute money you've already paid taxes in (take-home pay), but the investments grow tax-free and you can withdraw funds tax-free in retirement. Plus you can access your contributions (not growth) at any time without paying any penalties or taxes.
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