A tax-free retirement account (TFRA) is a special retirement savings account that allows you to collect money from savings and investments without paying tax on the income from the investment or the capital gains. It is a specific program designed by the government to allow people to reach their retirement goals with a lighter tax burden. Due to its tax-free nature, most individuals are only allowed to contribute a certain amount of money to tax-free retirement accounts per year, based on contribution limits.
Investors looking to reach their retirement goals with access to more money and income than Social Security have the option to turn to a tax-free retirement account. This account offers investors a chance to grow their retirement investments tax-free, even from capital gains taxes.
Though TFRAs require you to pay income taxes on your contributions, this difference could make a huge difference for someone in a lower tax bracket. You can hold cash in a TFRA, as well as stocks, bonds, and other investment vehicles. Keep reading to learn more about TFRAs, how they differ from traditional IRAs and 401(k)s, and which one could be best for your retirement plans.
TFRAs in the U.S.
There are two types of TFRAs in the United States: Roth IRAs and Roth 401(k)s. It’s important to stipulate that these two accounts differ from traditional IRAs and tax-free accounts.
The reason is that under a traditional IRA, the money is tax-deferred and not tax-free. This means that the Internal Revenue Service (IRS) doesn’t require taxes to be paid on what you initially contribute. Instead, they’ll tax what you earn from your investment. True TFRAs allow you to generate tax-free income and tax-free growth by investing after-tax income, without having to pay taxes in the future.
Federal, local, and state taxes in TFRA
Unfortunately, most of us pay more than just federal taxes. In addition to federal income tax, many Americans also pay state income tax and, in some cases, county or municipal tax.
Regardless of how much you pay in federal or state tax, the Internal Revenue code states that all taxes must be paid before you can contribute to a TFRA and eventually gain a retirement income. However, this money will grow tax-free, and any income you receive will not be taxed at either the federal, state, or local level.
|TFRA (2022)||Traditional setup (2022)|
|Pay all taxes before contributing||Pay no taxes before contributing|
|IRA contributions limited to $6,000 per person or $7,000 for individuals over 50 years||IRA contributions limited to $6,000 per person or $7,000 for individuals over 50 years|
|401(k) contributions limited to $20,500, or $27,000 for individuals over 50 years||401(k) contributions limited to $20,500, or $27,000 for individuals over 50 years|
|The account holder pays no taxes on any withdrawn funds||Account holder pays federal, state, municipal, and capital gains taxes on withdrawn funds|
Roth IRA vs. traditional IRA
An IRA is an individual retirement account, something that you use to invest money for retirement while taking advantage of tax benefits allocated by a specific government for that purpose.
The difference between a Roth IRA and a traditional IRA is in the timing and method of how they are taxed. A traditional IRA allows you to contribute pre-tax contributions, but a Roth IRA is funded with after-tax contributions.
A traditional IRA does not tax any income you contribute to your account. For instance, if you put $1,000 into a traditional IRA, that $1,000 isn’t counted toward your income tax.
Let’s say you make $100,000 per year and contribute $5,000 to your traditional IRA. If you have no tax deductions, then you will only be taxed by the government on $95,000 — the rest will go into your IRA tax-free.
However, you will need to pay income tax when you start taking withdrawals on dividends if you invest, as well as capital gains tax if you have investments that are growing.
A Roth IRA works differently than a traditional IRA because the money is being taxed before you put it into your IRA, or your TFRA. For instance, if you were making $100,000 a year and you contributed $5,000 to your Roth IRA, the $100,000 will be subjected to income tax. The $5,000 you are putting in will be $5,000 after you pay your federal income tax.
However, with a Roth IRA, you pay no income tax from any income generated from your investment, and you pay no capital gains tax if your investment grows.
401(k) vs. Roth 401(k)
A 401(k) is a qualified profit-sharing program set up by the government that gives an employer and their employees the ability to contribute money together for the goal of retirement. A 401(k) gives an employer the ability to match the retirement contribution of the employee.
Similar to the difference between a traditional IRA and a Roth IRA, the difference between these two 401(k)s revolves around the concept of when and how they are taxed.
In a traditional 401(k), an employer has the option of matching what you contribute for your retirement. For instance, let’s say that you contribute $3,000 a year towards your 401(k). Your employer matches you with $3,000. This means that you both contribute $6,000, which by deducting it, you both are exempt from tax on the $6,000.
However, the tax liability on the income and capital gains from the 401(k) will be deducted. In this scenario, you’re looking at tax-deferred accounts, not tax-free.
The concept of a Roth 401(k) is similar in its fundamental structure to a traditional 401(k). However, just like a Roth IRA, the tax structure is different. If you contribute $3,000 of after-tax dollars to your Roth IRA, and your employer also contributes $3,000 of after-tax dollars, you have a total of $6,000.
Remember that this time you pay taxes on the $3,000 that you contribute, and your employer pays tax on the income that he matches with. This way you’re able to obtain all the tax-free gains and income from your Roth 401(k).
Want to make sure you structure your 401(k) properly to maximize tax advantages? A certified financial advisor or investment advisor can help. Here are some options.
Should you use a traditional or Roth structure?
Deciding whether to use a traditional or Roth tax-free retirement account largely depends on your individual income. For example, if you are in a very high-income tax bracket, this is when you should consider a traditional IRA instead.
Let’s say that you pay 40% a year in income tax. In this scenario, the tax on your investment income from the Roth IRA is 10%. The tax on the capital gains after you exit your IRA is a 25% capital gains tax. In this case, it’s probably much smarter to go the traditional IRA route. This is because the income tax is far greater than that of any of the investment gains from your investment.
In the opposite scenario, let’s say the income tax you are paying on your income is around 10%. The same variables are constant, at 10% investment income and 25% capital gains. In this case, it’s much easier to pay the tax on your income before you contribute to your Roth IRA. This allows you to pay no tax on any of the income and gains, and only a small tax on your income.
|Designated Roth 401(k)||Roth IRA||Traditional 401(k)|
|Contributions||Designated Roth employee elective contributions are made with after-tax dollars.||Roth IRA contributions are made with after-tax dollars.||Traditional, pre-tax employee elective contributions are made with before-tax dollars.|
|Income Limits||No income limitation to participate.||Income limits:|
• 2022 — modified AGI married $214,000/single $144,000
• 2021 — modified AGI married $208,000/single $140,000
|No income limits to participate.|
|Max Elective Contribution||Aggregate* employee elective contributions limited to $20,500 in 2022; $19,500 in 2021 (plus an additional $6,500 in 2022 and 2021 for employees age 50 or over).||Contribution limited to $6,000 plus an additional $1,000 for employees age 50 or over in 2021 and 2022.||Same aggregate* limit as Designated Roth 401(k) Account|
|Taxation of Withdrawals||Withdrawals of contributions and earnings are not taxed provided it’s a qualified distribution — the account is held for at least 5 years and made:|
• On account of disability,
• On or after death, or
• On or after attainment of age 59½.
|Same as Designated Roth 401(k) Account and can have a qualified distribution for a first-time home purchase.||Withdrawals of contributions and earnings are subject to Federal and most State income taxes.|
|Required Distributions||Distributions must begin no later than age 72 (age 70½ if reached age 70½ before January 1, 2020), unless still working and not a 5% owner.||No requirement to start taking distributions while the owner is alive.||Same as Designated Roth 401(k) Account.|
* This limitation is by individual, rather than by plan. You can split your annual elective deferrals between designated Roth contributions and traditional pre-tax contributions, but your combined contributions can’t exceed the deferral limit – $20,500 in 2022; $19,500 in 2021 ($27,000 in 2022; $26,000 in 2021 if you’re eligible for catch-up contributions). (source)
Is a TFRA legal?
Yes, a TFRA is completely legal, provided you pay taxes on your income before contributing it to your TFRA.
Is TFRA a form of insurance?
No, a TFRA is not insurance. It’s a vehicle for retirement savings while minimizing your tax burden.
Is a TFSA available in the U.S.?
A TFSA (tax-free savings account) is only available in Canada and not yet in the U.S. However, the TFSA works similarly to a TFRA in that employees can contribute to this account after paying taxes on it. Once inside the TFSA, the contribution grows tax-free and can be withdrawn without paying capital gains taxes to the Canada Revenue Agency.
To qualify, you must be a resident of Canada, be over 18 years of age, and have a valid Social Insurance Number.
- A TFRA is a vehicle set up by the government to grow tax-free savings and investment for retirement.
- There are two versions of a TFRA in the U.S.: a Roth IRA and a Roth 401(k).
- The Roth (TFRA) structure differs from the traditional IRA and 401(k) structures because they are taxed differently and at a different time.
- In the Roth structure, you pay taxes on your contributions to the IRA or 401(k)beforehand. However, the income derived from the investment and any capital gains is tax-free.
- This differs from the traditional structure, where contributions are not incorporated in income taxes. That being said, you do pay taxes on both the income you earn from the traditional IRA as well as any capital gains from your investment’s growth.
- A traditional structure is better if you pay high tax on your earning income. On the other hand, a TFRA or Roth structure is better to use if you are in a lower tax bracket.
View Article Sources
- Roth IRAs — IRS
- Traditional and Roth 401(k) Plans — U.S. Securities and Exchange Commission
- How to Find a Financial Advisor You Can Trust — SuperMoney
- Behind on Retirement Savings? How to Reboot Your Retirement Plan — SuperMoney
- How Does Your 401(k) Plan Measure Up? — SuperMoney
- Ultimate Guide to Roth IRAs — SuperMoney
- The Complete Guide to 401k Plans — SuperMoney
- Ultimate Retirement Guide — SuperMoney