Financial Freedom Friday – Tax Free vs tax Deferred


Hi everyone! Welcome back to Financial
Freedom Friday where we discuss tips and strategies to help you achieve
financial freedom. My name is Nate Scott, great to be here with you again.
Today we’re talking about a hot topic in the world and it has been for quite some
time, and that’s the difference between tax deferred accounts and tax free
accounts and which ones you ought to devote the majority of your money to. So that’s what we’re gonna talk about. The differences, and also a three
main questions that you should ask yourself when you’re really determining
which one you want to go into. So just to relate to you what we’re doing.
Tax deferred accounts- those are things like your traditional IRAs and
your 401(k)s. Those are things, what they mean when they say tax deferred, every dollar you put into it you actually get to deduct on this year’s
tax return. So if I contribute $10,000 to my 401(k), I have $10,000 less of income
that year that I have to pay taxes on. So if I make $100,000, I deposit
$10,000 into that account then I really am only taxed on $90,000. A lot
of people think that’s great and it’s kind of a short-term mindset though, it’s
like kicking the can down the road because we do know that if anytime in
the future when we want to pull money from those accounts, when we retire or anytime sooner than that, all the distributions, 100% of the money that
comes out of that, is gonna be taxed at the normal income tax level. So it’s not
like it’s a real expense it’s just, it’s a deferment. It just defers your taxes
into the future. The other option is what’s called the tax-free accounts, you
could say, which are conventionally your Roth IRA and whole life insurance are the
main type of tax-free accounts where you put in after-tax dollars into
the account. Meaning if we had $100,000 of income and we put
$10,000 in, we still pay taxes on the full $100,000. So we don’t
get to deduct the money we contribute to those, the Roth IRA and
and the policy, but when it comes to income time we get to take all the
distributions and not pay taxes on those. So 1. we pay taxes as we build it, the other one we pay less taxes as we’re building but we have to
pay all the taxes when we start distributing it. And so when
deciding which one you want to do it’s good to ask three main questions and
that will kind of help you see, in reality, which one you really ought to
focus on. So the first question you got to ask yourself is do you think taxes
are going to go up or down in the future? Now, if you’re like most of us, we look at
the national debt, we look at the spending issues in Congress, no matter
who’s elected in, and we say, wow I really don’t think taxes are
gonna go down. They’re probably gonna go up. But the main benefit for the tax
deferred accounts, what people are saying why we should do those, is that
hey, you’ll be in retirement. You probably won’t need as much to live, you’ll have
less income, so the chances are high that you’ll be in a lower tax bracket and not
have to pay as much tax. So they say let’s just defer it down to that
point. Well, first off, I don’t really want to live on less in the first place
in retirement to begin with, so that’s not too exciting if that’s the rationale.
But even if that was the case, even if we did have less income in the future the
problem is if taxes actually go up, even if your income goes down in the future
when you retire you still might be paying the same amount in taxes anyway.
Because your income, even though it went down, if you’re paying a higher
percentage on that income anyway, it could probably just wash out. So if you
really feel the taxes are gonna go down you and you’ll be in a lower tax bracket
in the future, maybe the tax deferred route. But for most of us we’re not even
seeing that happening. I would rather just take tax-free income
in the future to be honest. But that’s not even taking into account the Social
Security taxes in the future. If you make more than $32,000 as a
couple then your Social Security benefits start getting taxed. So essentially if you’re looking to pull out more than $30,000 a year
practically from your retirement programs, then now
all the Social Security income is starting to be taxed depending on how
much income you have outside. And so either way, ask yourself if you think
taxes are gonna go up or down and how much income will your income really
decrease by very much in retirement? And that will kind of help you choose which
one to do. The second question you should ask is, is $1 worth more today or in the
future? All tax deferred accounts require your money to sit. 401(k)s, IRAs,
they will penalize you if you take out the money before 59 and a half. So we
have to let the money just sit in there even if we wanted to retire early. I mean
there are some stipulations, but most of the time you can retire
early or want to get out and want to use the money now, then you have to pay taxes
and a penalty on it. So they make you stick it in there and they don’t want
you to ever touch it. The problem is, as we know, dollars are worth more today
than they will be 30 years from now. And we would rather try to figure out ways
to use the good dollars today and that’s what I love about that the tax free
account since we’re putting in after tax dollars it’s very easy to pull money out.
We don’t have to wait 30 years to pull money out and we don’t get penalized for
it and we don’t pay taxes on it. For the most part. I’m not giving tax
advice, there’s a lot of things, especially with the Roth IRA, I’m not
gonna get into that, but generally there is some money that you can
pull out without taxation. And so we would like to try to be able to use
money now instead of pushing it back into the future if we need it. And so ask
yourself is a dollar worth more today or in the future and will I want to use
more of the good dollars today. We don’t know what a dollar’s gonna be worth
thirty years from now. We don’t know what your tax bracket’s gonna be, and we don’t
know what the dollar’s gonna be worth. So maybe locking money up might not be the
best. Maybe being able to use it is better. And the third question you
oughta ask yourself is would you rather pay taxes on the seed or the harvest?
Would you rather pay taxes on the big amount that all your money has grown to
in the future on the harvest, or would you rather pay taxes on the little
amount that you put into the account that grew into this large harvest? Many
people that I know would rather pay taxes on the little
amounts that they deposited into it than on the big amount that it’s
compounded, and that it’s built to, because hopefully your account is worth
far more than your contributions. So would you rather pay taxes on the little,
smaller amount of the contributions or the large amount that it’s grown to?
Many times it’s much better just to simply pay tax on the little amount and
know without a shadow of a doubt that you can pull money out without having to
pay taxes on it in the future on the large amount. Pull out as much as you
want without having to worry about taxation. That is a good place to be. So
if you can’t tell, I’m a big fan of tax-free accounts. I don’t like the
guesswork on the tax deferred accounts that we have so many questions,
we don’t know what it’s going to be in the future. So I’d like to make decisions
that I know and I can understand today and let the future be what it’s
gonna be. But I know that I’m set up to do well. So remember guys, if you don’t
build your financial freedom nobody will. So figure out what you want
to do and stick to it. And let’s get to work. See you next week.

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