We often hear questions and see confusion regarding the terms taxable, tax deferred and tax-free.
Taxable: This means it is something that will be claimed on your tax return and you are subject to taxes on that income.
Wages are taxable: the gross amount, before the payroll tax deductions, is what you report as taxable. The net, the amount after all your deductions and the amount that you receive in your paycheck, does not matter when it comes to income taxes.
For example, if you are making $20 an hour for 40 hours, it means your gross is $800. You will have Social Security, federal and state income taxes withheld. You may have to pay union dues, may elect to put money into a retirement plan, buy additional insurance, etc. All of these will reduce your paycheck. While your gross paycheck is $800, your net paycheck may be $550. You will be paying taxes on the $800.
There are lots of different types of taxable income including pensions, Social Security interest, dividends, capital gains, rents, gig economy, royalties and more.
Tax Deferred: This is saying that you do not have to pay taxes on that income today. You will be paying taxes on the income in the future. When you have funds withheld from your paycheck to be put in a pre-tax 401(k), 403(b) or 457, this is a type of tax deferral.
Take that $800 of wages from the taxable example and say that you elect to put 10% into your pre-tax 401(k) which would be $80 ($800 x 10%). The tax on that $80 is tax deferred. You will currently only be paying taxes on $720, the $800 less the $80 tax deferred.
Tax deferred does mean that you eventually will have to pay taxes. When you start drawing that money out of your pre-tax 401(k), you will have to pay taxes on that initial $80 contribution. Whatever that $80 contribution has earned since it went into the 401(k) has been tax deferred. No taxes are paid on those earnings until they are withdrawn out of the account. Since both the initial contribution and the earnings have not had taxes paid on them, they were tax deferred and become taxable at the time the funds are withdrawn.
Tax-Free: This is saying that you do not have to pay taxes on that income today AND you will not have to pay taxes on that income in the future.
Certain types of government bond interest income can be federal tax free, state tax free and/or local tax free. For example, US savings bonds are tax-free for state purposes yet taxable on your Federal tax return.
One of the main reasons we at Planning with Purpose love Roth IRAs is because this is tax-free income. When qualified distributions are made from Roth IRAs there is no tax due on the amount being withdrawn. Both the original amount you put in comes out tax-free AND the earnings come out tax-free. We will discuss this much more in depth in a later post.
When comparing different types of income, to have a true picture you should be including the impact that taxes will have when that income is received or earned.
