Tax Free vs. Tax Deferred
These are two concepts that are frequently misunderstood. Both have differing impacts on your current and future tax liabilities.
TAX FREE
Typically, this is dividend income coming from investments in municipal securities, primarily bonds. State and local bond investment dividends are tax free on your federal tax return and will also be tax free if you live in the state that they are issued in. If you purchase a municipal bond mutual fund, you will need to follow the fund’s year end directions to see if some of the dividends are applicable to the state you are living in. Income from states other than the one you live in are fully taxable in your current state.
While dividends from Municipal Bonds are generally tax free to you, there is still a capital gain treatment for when you sell them. You will need to calculate the gain or loss on them and pay tax on any capital gain you may have incurred even though the dividends were tax free during ownership.
Another way to get tax free income now but deferred into the future is by opening up Roth IRA/ Roth 401k and contributing to it with after tax dollars. Providing you keep the account open for at least 5 years, you can withdraw income tax free for your lifetime and for the lifetime of your beneficiary. In the meantime, the income it earns is tax deferred… The disadvantage is that you are not getting a tax deduction for contributions currently.
TAX DEFERRED
This concept of deferring tax on income to some time in the future can be explained by Traditional IRA’s, individual retirement plans and traditional company retirement plans as well as fixed or variable annuities.
What you are doing here is postponing income tax both Federal and State until some time in the future when you begin to collect income or take a distribution. Contributions are generally deductible (limitations exist for Traditional IRA’s and will be addressed in a future article).
When you begin to take an income from an account that was funded pretax, you will be taxed on the distributions and their earnings as you receive them. IRA’s and other retirement plans force you to begin taking Required Minimum Distributions when you hit age 72 rather than age 70 ½ under prior laws.
Annuities, typically don’t specify an age when you must take distributions, unless they are purchased as a qualified retirement plan. However, your heirs will pay the taxes due when they inherit it and you will pay tax on the earnings as you take distributions. Until you take distributions or annuitize the tax is deferred on the earnings.