Many countries have tax-deferred accounts, such as the 401(k) plan in the United States and Registered Retirement Savings Plans (RRSPs) in Canada. Savings deposited in a tax-deferred account are tax deductible in the contribution year, returns grow tax deferred until withdrawn, and withdrawals are taxable as ordinary income. The United States has tax-exempt accounts, and beginning in 2009, Canada will also have these accounts. Savings deposited in a tax-exempt account are not deductible in the contribution year, but withdrawals, including accumulated returns, are generally tax exempt.

Many U.S. and Canadian investors will have to choose between saving in a tax-deferred account or in a tax-exempt account. For example, many U.S. employees can save up to US$15,500 per year (or US$20,500 if over age 50) in either a tax-deferred 401(k) or a tax-exempt Roth 401(k). In Canada, taxpayers can contribute up to the lower of C$20,000 or 18 percent of earned income in a RRSP. Beginning in 2009, individuals age 18 and older will be able to contribute up to C$5,000 to a tax-exempt Tax-Free Savings Account (TFSA); a couple could contribute up to C$10,000. Other countries may follow these countries’ lead and provide their citizens with the opportunity to invest in tax-exempt accounts. This discussion is designed to help these investors choose between saving in tax-deferred or tax-exempt accounts.

Example
Gayle is bright, energetic, and 35 years old. She is saving for retirement and willing to reduce this year’s spending by US$7,500. She works at a U.S. company that allows her to save in a tax-deferred 401(k) or a tax-exempt Roth 401(k). She must decide which savings vehicle is better for her. Her decision is similar to other U.S. investors’ decisions to save in a traditional IRA or a Roth IRA or to convert funds from a traditional IRA to a Roth IRA. Beginning in 2009, Canadians will face similar decisions whether to save in a RRSP or TFSA. A key factor in these decisions is the comparison between today’s tax rate and expected tax rates in retirement.

Choice of Savings Vehicles
Assume Gayle has a 25 percent marginal tax rate this year. She is willing to reduce this year’s spending by US$7,500, so she could contribute either US$7,500 of after-tax funds to a tax-exempt account (henceforth, exempt account) or US$10,000 of pretax funds to a tax-deferred account (henceforth, deferred account). The US$10,000 contribution to the deferred account would reduce taxable income by the same amount, which would reduce taxes by US$2,500. She could have $2,500 less withheld in taxes this year, so the $10,000 contribution to the deferred account would reduce the amount Gayle could spend this year by only US$7,500. These investment amounts are comparable because they will each decrease this year’s spending by US$7,500. Any company-matching contribution should not affect her decision because it would go into a deferred account.

In Table 1, the ending after-tax wealth from a US$7,500 contribution to an exempt account is compared with the ending after-tax wealth from a US$10,000 contribution to a deferred account. Note that the table is based on a 100 percent cumulative pretax return before retirement and marginal tax rates in retirement of 15 percent, 25 percent, or 35 percent.

If Gayle has a 15 percent retirement tax rate, the deferred account would be worth US$20,000 before taxes but US$17,000 after taxes. The US$7,500 in the exempt account would double to US$15,000 after taxes. If she has a lower tax rate in retirement, the deferred account would offer the higher after-tax wealth.

If she has a 25 percent retirement tax rate, the deferred account would be worth US$20,000 before taxes but US$15,000 after taxes. The exempt account would be worth US$15,000 after taxes as well. If the tax rates today and in retirement are the same, the after-tax wealth from savings in the deferred account and exempt account would be the same.

If she has a 35 percent retirement tax rate, the deferred account would be worth US$20,000 before taxes but US$13,000 after taxes, which is less than the exempt account’s US$15,000 after taxes. If she has a higher tax rate in retirement, the exempt account would offer the higher after-tax wealth.

Other Factors
Although the comparison between this year’s tax rate and expected tax rates in retirement is usually the key factor in the choice of saving vehicles, other factors within each country may influence this decision. Because Gayle lives in the United States, these factors are related to the U.S. tax code. But an initial analysis suggests that most of these factors should also influence Canadians’ decisions.

First, the maximum annual contribution limit is the same for the deferred account and exempt account, but this limit does not take taxes into consideration. Because she is younger than 50, Gayle could contribute up to US$15,500 to a deferred account or an exempt account in 2008. But a US$15,500 contribution of after-tax funds to an exempt account is effectively a larger contribution than a US$15,500 contribution of pretax funds to a deferred account. In the example, the maximum contribution limit was not a factor because Gayle was willing to reduce this year’s spending by only US$7,500. But if she wanted to make the largest possible after-tax contribution, she should contribute to the tax-exempt account. In Canada, the contribution limits are different for the tax-deferred RRSP and tax-exempt TFSA, but the concept that after-tax dollars are larger still applies.

Second, in the United States and Canada, no minimum distributions from an exempt account are required, but minimum distributions from a deferred account are required.¹

Third, distributions in retirement from Gayle’s deferred account may cause more of her Social Security benefits to be taxable or to be taxed at a higher rate, whereas distributions from the exempt account would not affect the taxation of these benefits. In Canada, withdrawals from a RRSP can affect eligibility for government income-tested benefits and credits.

Fourth, if Gayle is like most people, she has substantially more funds in deferred accounts than exempt accounts. Contributions to a deferred account would eventually be taxed at retirement tax rates, but contributions to an exempt account are taxed at today’s tax rate. She may prefer to save in an exempt account as a tax-diversification play to reduce the concentration of funds that will be taxed at future tax rates. This concept should also affect Canadians’ decisions.

Fifth, if Gayle itemizes deductions for income tax purposes, her deductions for business expenses, casualty losses, investment expenses, and medical expenses may be affected by the choice of savings vehicles. For example, medical expenses exceeding 7.5 percent of adjusted gross income (AGI) are deductible. If she saves in the deferred account, she will have a lower AGI, and therefore, more of these expenses will be deductible this year. Although saving in the deferred account will lower this year’s AGI, it will raise her AGI during retirement once required minimum distributions begin. Similarly, in Canada, by contributing to a RRSP, some individuals may sufficiently reduce this year’s taxable income to become eligible for government income-tested benefits and credits.

Conclusion
The first step when deciding between saving in a deferred account or an exempt account is usually to compare the marginal tax rates today and in retirement. If you expect to have a lower tax rate in retirement, then everything else the same, you should save in the deferred account, and vice versa. If you expect to have the same or similar tax rates today as in retirement, other factors may determine the saving decision. Other factors can affect the choice between a tax-deferred account and a tax-exempt account,² but most of those listed here favor saving in the exempt account.

Table 1. After-Tax Wealth in Retirement from Saving in a Tax-Deferred Account and a Tax-Exempt Account