Ask the Expert: Explaining what is owed with tax-deferred retirement accounts

We’re old enough to take penalty-free withdrawals from our tax-deferred 401(k) and 403(b) accounts. Does “tax-deferred” mean that when money is withdrawn, tax is owed on accrued dividends and capital gains as well as on changes in share price over time, or on just some of these factors? How much tax advantage is gained from putting money in tax-deferred retirement accounts vs. taxable mutual funds?

In tax-deferred retirement accounts, there’s no distinction for dividends, capital gains or changes in share price. All the money you withdraw from your account is taxable as ordinary income, except for any contributions you may have made with after-tax dollars. There’s no tax on those contributions when you withdraw them because they’ve already been taxed. Even when the government waives the 10% early withdrawal penalty for retirement account distributions taken before age 59½, it doesn’t waive the taxes.

There are four advantages to saving in a 401(k) or 403(b) plan instead of a taxable account:

• Pre-tax contributions cut your tax bill. If you earn $100,000 and contribute $8,000 to the plan, for example, you pay taxes on only $92,000.
• Your employer may match your contribution.
• Your investment earnings aren’t taxed annually, as they are in a taxable account.
• Withdrawals are taxed after you retire, when your tax rate may be lower.

The downside: After turning 73, you must take required minimum distributions (RMDs) from your tax-deferred accounts whether or not you need them, and the withdrawals are taxed as ordinary income. By contrast, there are no RMDs from taxable accounts, and the profit on some taxable account investments is taxed at lower capital gains rates.

The bottom line

Withdrawals from tax-deferred accounts are subject to ordinary income tax.

More information

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