A tax free account is an incredibly valuable device for effective retirement saving.
What does it mean if something is tax free?
An account is tax free if there is no tax due on income earned in the account, neither when it is earned nor when it is distributed.
What are examples of tax free accounts?
There is only one tax free retirement account: the Roth IRA. Another example of a tax free account is a 529 Savings Plan, but in for such funds to become tax free, they must be used for qualified education expenses. Note that a regular IRA (also known as traditional) IRA is tax deferred. An annuity and the cash surrender value of a whole life insurance policy also operate as tax deferred accounts. With a tax deferred account, taxes are due at the time of distribution.
How is a tax free account different from a tax exempt account?
Individuals can't establish tax exempt accounts. However, they may invest in bonds which pay tax exempt interest. Typically such interest is exempt from federal tax. However, if the bond represents the debt of a state other than the individual's residence, that interest will be taxable on his state income tax return.
How does it work if an account is not tax free?
All investments have the potential to pay income, increase in value, or both. Income comes from two primary sources: interest and dividends. If an investment is held in a taxable account, the income is added to the owner's taxable income for the year and results in a higher tax liability. Any sales of assets held in a taxable account which are sold for more than what was invested will also result in increased income and income tax. No tax would be due if the same investments were held in a tax free account - a significant advantage to holding investments in such a tax free account.
Will I get a tax deduction for a contribution made to a tax free account?
In short, no. The benefit of a tax free account is the tax free growth. The trade-off is that you do not get a deduction for the initial contribution to the plan.