Tax Free Retirement Account (TFRA)

In a nutshell:

A tax free retirement account (TFRA) lets your retirement savings grow tax-free or tax-deferred. There are different types, and there are some requirements to be aware of.
Tax-deferred retirement accounts include traditional 401(k)s and IRAs. They delay taxes until retirement, leaving you with more to spend today.
Tax-exempt retirement accounts include Roth 401(k)s and Roth IRAs. They take your tax upfront so you don’t owe taxes when you withdraw your retirement savings.

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Note: This article refers to TFRA retirement accounts, not TFRA life insurance plans (also called a Section 7702 plan). If you’re looking for the latter, these sites may help.

What is a Tax Free Retirement Account (TFRA)?

A tax-free retirement account is a type of retirement savings plan where your withdrawals in retirement are not subject to income taxes, as long as certain conditions are met. The most common example of this is a Roth IRA or a Roth 401(k). You may also hear it called a ‘tax-advantaged retirement account’. Same thing!

TFRAs offer tax benefits that regular savings and investment accounts don’t, making them a great way to grow your money for retirement.

Here's how it works:

You contribute money to the account after you've already paid taxes on it (with after-tax dollars).
The money in the account grows over time: through interest or investments.
When you retire and take money out (withdrawals), you don't owe any taxes on those withdrawals, as long as you follow the rules (e.g., being 59½ or older and having the account for at least five years).

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This makes tax-free retirement accounts appealing for people who expect to be in a higher tax bracket when they retire, or who want to avoid paying taxes on their retirement income.

There are also Tax-deferred retirement accounts:

These include traditional 401(k)s and traditional IRAs
You don’t pay taxes when you put money in
You do pay taxes when you take money out

Tax-exempt retirement accounts:

Includes Roth 401(k)s and Roth IRAs
You do pay taxes when you put money in
You don’t pay taxes when you take money out

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Who are TFRAs for?

Tax free retirement accounts (TFRAs) are for people who want to save for their retirement in a tax-efficient way.

At some point, you’ll have to pay tax on your retirement savings: now or later. But when you pay it could affect the overall amount of tax you pay.

Regular earners: Paying into a tax-exempt account like a Roth 401(k) or Roth IRA can be smart if you think you’ll earn more in the future. You’ll pay your tax now, while you’re in a lower tax bracket. Then your savings will grow tax-free, and you won’t owe any tax when you take the money out in retirement.
Higher earners: Paying into a tax-deferred account like a traditional 401(k) or IRA can help reduce your current taxable income. You won’t pay taxes on your contributions until you withdraw the money in retirement (you pay later), by which time you may be in a lower tax bracket which could reduce your overall tax bill.

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It’s not always this simple, though. Income doesn’t always follow a straight path, and many people’s earnings go up and down over time. In this case, having both a traditional 401(k) or IRA and a Roth 401(k) or Roth IRA can give you the flexibility to contribute to the most tax-efficient account as your circumstances change.

How do TFRAs work?

Tax free retirement accounts work by offering tax benefits either when you contribute money or withdraw money, depending on the type of account.

Tax-deferred retirement accounts

If you have a 401(k), you can contribute some of your income directly from your paycheck. The amount will be taken out before taxes are calculated, reducing the amount of tax you have to pay today.
If you have a traditional IRA, you’ll pay into it with your own money and claim back the tax deduction when you file your yearly tax return.
The money in your retirement account will grow tax-free.
You’ll pay income tax on the money when you withdraw it in retirement.

And the small print...

There’s a limit on the amount you can contribute to a tax-deferred retirement account each year, which is updated annually by the IRS.
There’s also a minimum amount you may have to withdraw (if you have a Traditional IRA) each year starting at age 73, called Required Minimum Distributions (RMDs).
If you want to withdraw money before you turn 59½, you’ll usually have to pay a 10% penalty on top of income tax.

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Tax-exempt retirement accounts

If you have a Roth 401(k), you can contribute a portion of your after-tax income. You won’t be able to claim a tax deduction when you file your yearly tax return.
The money in your retirement account will then grow tax-free.
You won’t pay income tax on the money you withdraw in retirement, as long as you meet certain criteria.

And the small print...

There’s a limit on the amount you can contribute to a tax-exempt retirement account each year, which is updated annually by the IRS.
For Roth 401(k)s, there’s a minimum amount you have to withdraw each year (called a Required Minimum Distributions of RMD) starting at age 73 (from 2023). Roth IRAs don’t have RMDs.
The Roth 401(k) RMD can usually be avoided if you roll it into a Roth IRA.
If you withdraw money before you turn 59½ and before the account is 5 years old, you’ll usually have to pay a 10% penalty and taxes on the earnings.
Unlike traditional 401(k)s and IRAs, you can withdraw your contributions (not earnings) from a Roth IRA anytime without penalty, since you’ve already paid taxes on the initial contribution.

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Are TFRAs a good choice?

Tax free retirement accounts (TFRAs) are a great choice for most people saving for retirement due to their tax benefits.

When we think about the pros and cons of TFRAs, we’re really comparing them to traditional saving and investing. If you’re saving for retirement, there aren’t many better ways to do it than paying into a TFRA because of the tax benefits - whether up-front or during retirement.

The alternative for most people is to put their money in a traditional savings account or invest it in taxable accounts. But in both cases, they’re not getting any tax benefits.

TFRAs may not be all you need to save for retirement, depending on your goals. But they’re a solid foundation to build your future wealth.

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Retirement planning can be difficult. That’s why, at PensionBee, we help you roll your old 401(k)s from previous jobs into an Individual Retirement Account (IRA). Not only does it make it easier to stay on top of your retirement savings, it also gives you more freedom to invest in the types of things you want!

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FAQs

Is a Roth IRA tax deferred?

No. A Roth IRA is a type of tax-exempt retirement account. This means you pay tax on your contributions upfront and you don’t owe any tax when you withdraw your retirement savings.

Traditional IRAs are tax-deferred, however. This means you delay paying tax until retirement, leaving you with more to spend today.

Is a Roth IRA’s capital gains tax free?

Yes, capital gains within a Roth IRA are tax-free, as long as certain conditions are met. For example, you’ll need to have had the Roth IRA for at least five years and be 59½ or older.

Is a Roth IRA tax free after 5 years?

Yes. To get the tax benefits of a Roth IRA, you’ll need to have had it for at least five years. If you withdraw money before that time, you may have to pay tax and penalties on the earnings portion of your withdrawal (you can withdraw your original contributions anytime without penalty).

Is a Roth IRA tax-free to beneficiaries?

Yes. So long as certain conditions are met, beneficiaries can inherit a Roth IRA tax-free. If you’re a legal spouse, the Roth IRA will work the same as if you set it up yourself. If you’re not, you usually have to withdraw the full Roth IRA within 10 years.

Does a traditional IRA grow tax free?

Yes, a traditional IRA grows tax free. But it’s important to understand that while you won’t have to pay tax when you contribute to the IRA, and that the investments themselves will grow tax-free, you’ll have to pay tax when you withdraw money during your retirement. This is why it’s commonly referred to as a tax-deferred retirement account.

Can I convert a 401k to Roth IRA tax-free?

No, you can’t convert a traditional 401(k) to a Roth IRA without paying tax. When you roll over money from a traditional 401(k) to a Roth IRA, you’ll owe income tax on the amount you convert in that year. This is because traditional 401(k)s are funded with pre-tax dollars, while Roth IRAs are funded with after-tax dollars. So the untaxed money from your 401(k) becomes taxable when moved into a Roth IRA.

Are withdrawals from retirement accounts taxable?

Some retirement account withdrawals are taxable. You will have to pay tax on withdrawals from tax-deferred retirement accounts, such as traditional 401(k)s and IRAs because you didn’t pay tax on your initial contribution. But you won’t have to pay tax on withdrawals from tax-exempt retirement accounts, such as Roth 401(k)s and Roth IRAs because you already paid tax on your initial contribution.

How can I get tax free income in retirement?

You can get tax free income in retirement by contributing to a tax-exempt retirement account, such as a Roth 401(k) or Roth IRA. Instead of paying tax on withdrawals, you’ll pay tax on the initial contributions. This can be an effective way to save if you’re a regular earner and think you’ll earn more in the future.

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