Tax-deferred vs. tax-exempt retirement accounts: Which is right for you?

The income taxes you pay during your lifetime can significantly impact your lifestyle in retirement, as well as how much you leave behind for the people you care about. That’s why holding your retirement savings in accounts that offer tax advantages is a powerful strategy for wealth creation.

Contributions to tax-deferred accounts, including individual retirement accounts (IRAs) and 401(k) plans, can reduce the taxes you pay that year. These accounts are particularly valuable for high-net-worth individuals, who are likely to be in a higher income tax bracket that year and have more investments that are vulnerable to taxation.

To use these accounts effectively, it’s key to understand how a tax-deferred account and a tax-exempt account, such as a Roth IRA or Roth 401(k), work. Each has its own tax implications that are better used at different times, depending on your goals, income and life circumstances.

Tax-deferred accounts allow individuals who meet eligibility requirements to contribute earned income on a pre-tax basis, up to contribution limits set annually by the IRS. Interest, dividends and appreciation on these investments are not taxable until money is withdrawn in retirement , when the ordinary income tax rate applies.

Using a tax-deferred account is particularly beneficial if you have higher income, since you are likely to be in a lower tax bracket in retirement than you are during your working years.

Contributions to tax-exempt accounts, by comparison, are made with after-tax money, but qualified withdrawals are tax-free in retirement. Roth IRA accounts and Roth 401(k) plans are tax-exempt retirement accounts, though not all 401(k) plans offer a Roth option.

Tax-exempt accounts make the most sense for people who expect to earn more money in the future than they do today. In this scenario, the current income taxes you pay on contributions could be substantially lower than what you would pay in retirement.

Tax-exempt retirement accounts are often advantageous for people early in their careers, because while anyone can contribute to a Roth 401(k) regardless of income, the ability to contribute to Roth IRA accounts phases out at higher annual income levels.

The good news is that you don’t have to choose between tax-deferred and tax-exempt accounts. In fact, there may be an advantage to saving across a mix of the two. This strategy could provide flexibility that can be far more effective than one that attempts to forecast future tax rates.

For example, you might choose to maximize tax-exempt Roth IRA contributions early in your career, when your income falls within the eligibility limits, while also contributing to a tax-deferred employer-sponsored 401(k) plan.

This approach to tax diversification sets you up to take advantage of a dynamic decumulation strategy in retirement, in which you draw from your retirement funds in whichever sequence is more tax efficient. Doing so allows you to manage your liabilities without compromising on meeting your goals if changes in tax rates differ from what you’re expecting.

Incorporating these tactics can help you grow your lifetime wealth substantially. It also can help in organizing your financial life into three strategies: Liquidity. Longevity. Legacy. These are core to a UBS approach to wealth management called UBS Wealth Way . No matter which path you take, it’s critical to have experienced, professional guidance as you pursue your goals and build the legacy you envision.