Tax Free vs. Tax Deferred – Episode 419

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[00:00] Hello, listeners. We’re tackling the subject of tax-free versus tax-deferred. I’ll tell you what, I don’t even like talking about taxes, but it’s necessary evil. And Kim, you’ve taught me over the years, taxes are a good thing because it means I’m making money, right? It does. I just shared with a client today, I would rather have you make a million dollars of income every single year and pay $400,000 in tax than to be trying to win a race to the bottom, which is where the tax-free space often lies. When we’re trying to get to zero tax, tax-free, lowest tax bracket, et cetera, that’s a race to the bottom. You cannot win a race to the bottom. And yet there are so many things out there that are talking about that. And I get it. It sounds appealing. And yet tax-free, not that

[01:01] there aren’t some legitimate things that are tax-free, like Roth IRA is an example. Nevertheless, tax-free everything means you’ve won the race to the bottom. I’m not seeing how that’s helpful. Yeah. You know, it reminds me, I’m not going to name names because I don’t want this to come back to me, but I had a friend in our twenties and his game was the savings game. And it got so bad that before he left for work, he’d go around the house and unplug the TV and unplug everything around the house. And I go, what are you saving? Five bucks a month? Is this really worth it? And that’s what this game seems like at times. You know, you hear these all this tax-free hoopla. And is it there and say, OK, no, no, we’re going to think

[01:49] from a prosperous mindset. So let’s back up. Give us big picture, Kim, of tax-free versus deferred. Let’s go into a few of those and then we can get some nitty gritty details. Absolutely. So tax-deferred assets are things like, technically, life insurance. We’ll come back to that as to why I’m putting it in the tax-deferred account and not the tax-free account. Also, qualified plans like 401ks, so tax-deferred again, IRAs, 403Bs, pension, profit-sharing, KEOs, the new solo 401ks, et cetera, all of those are tax-deferred, meaning typically that you put money in, you get a tax deduction. It then grows without taxes. That’s the tax-deferral part. And then it comes out taxable. So typically when people say the word tax-deferred, they’re talking about

[02:46] how it grows. You could say real estate grows in a tax-deferred way. You could say an individual stock grows in a tax-deferred way because you don’t pay taxes while it grows. Of course, you do when you sell it. So I think as a general rule, it’s not called tax-deferred. But technically, if you have an asset that’s growing and you’re not paying tax every single year, then that is deferring the tax. So any of those types of assets are tax-deferred. And then tax-free typically means that the growth is not ever going to be taxed. In other words, not only is it not taxed while it grows, so think again like a Roth IRA is the easiest example, but it is also not taxed when you sell or when you pull money from it or when

[03:36] you take it out. And there are very few things like that. Life insurance does often get talks about as a tax-free account because it can be tax-free. While you’re borrowing against it and paying it back, those loans are not taxed. So those are tax-free like any loan is. Nothing magical about them. However, there is a lot of noise on the internet about continuing to borrow against the policy in the later life and making it continue to be tax-free. And I just want to make a note, not the subject necessarily of this particular podcast, but make a note that that could work if you didn’t live very long, like if you were absolutely assured you were going to die in your 80s or 90s. But if you’re going to live till your

[04:25] late 90s, 100, 110, 120, 130, that’s an awfully long time to have a loan on the books. And if you did survive that long and you had a loan on the books that long, what would probably happen is your policy would implode, meaning it would fall apart from the inside. And that is a 100% taxable event and not a pretty one because it means a very, very large loan and all of that previously tax-deferred growth becoming taxable in a single year, not something you want to have happen at all. So just to step back from that quick side note, the basic difference again, tax-deferred means no growth on the taxation, tax-free typically means no taxation on the growth and tax-free means typically no taxation when you pull the money out either.

[05:27] There you go. And just as a caveat listeners, this isn’t tax advice to talk with your accountant and your experts out there on your specific situation. This is to help you understand how wealthy people are managing assets and understanding the differences because we have listeners at various ages. We’ve seen young listeners that are listening to these episodes with their parents in the car all the way to people that are planning for the final years and they’re bringing in grandchildren or whatever that may be. So is that a good caveat onto that? Absolutely. And I love that we have such a wide listenership because it’s such a cool thing to be able to help with. And as we continue down this path, I want to share something that Tom Willwright actually

[06:18] shared with me recently. And that is there’s seven different things that are investment oriented that get you tax benefits. Now we have to see if I can remember all seven because I’m not able to find my notes quickly. And one of them is insurance. So we do need to acknowledge that insurance can absolutely be tax-beneficial, tax-deferred, tax-free death benefit, tax-free loans, et cetera. One of them is real estate, of course, oil and gas and other sectors of energy, solar credits, that kind of thing. Businesses, of course. Retirement plans, of course. There are some tax benefits. We could argue whether they’re effective or not, but they are there. I know there was a couple others. I’ll see if I can

[07:05] come up with them. But I thought it was neat how he just line-itemed them all for us to just be aware that taxes are our biggest expense. And we absolutely want to be doing what we can to have the potential to reduce them legally, of course. And I’ll be frank, if you’re a W-2 employee other than your own home mortgage, ah, that was another one right there, primary residence, in other words, separate from actual investment real estate, then the idea of having the employment income, you know, not really having any other tax benefits, but now with home offices and everybody working virtually, et cetera, how valuable it is to form a business in some form or fashion. And I know we’re going to do another podcast on this, but

[07:58] the ability to be able to deduct things like home offices and other aspects of our lives, so businesses being one of those seven as well, super, super helpful. And not something that everybody was thinking about in 2019, but of course, as soon as 2020 hit, and if you didn’t get it figured out in 2020, then 2021 is the year to figure out a way to have a business so that so many more things can be deductible, super valuable from a tax standpoint. Yeah, absolutely. So I’ve written down this list right here. You know, we have this tax-free list and we’ve got a tax-deferred list. And then there’s just different tax advantages, things that can be done. You know, on the podcast, we’ve talked a lot about insurance. We’ve talked about oil and gas and how that is available primarily

[08:48] for accredited investors. Is that correct? Correct. Okay. And then the business Kim is talking about right now, and we’ll have a follow-up episode that’ll be really helpful. Business is something that anyone can do. In fact, a lot of you as younger listeners, you can start to think of business ideas, and that can go from as young as we’ve seen grade school children coming up with ideas to older. Colonel Sanders didn’t really hit his home runs until he was in his senior ages, so it can happen for anyone. I love his story without a doubt. And on the younger set, I know we’ve talked about it before, but myfirstsale.com, my first sale, S-A-L-E, such a cool website in terms of the younger entrepreneurial ideas and opportunities and methods of just creating that mindset.

[09:43] Yes, it’s wonderful. So, you know, as we talk about tax-free versus deferred, there is a language that Kim uses that I’ve heard you say all the time. There’s the traditional way of thinking and the typical way of thinking. And unfortunately, most of the things that you’re going to read from a newsstand is going to be typical. Most of the things you see on TV is typical. The things that wealthy people do is a lot different. Do you want to touch on a couple of those? Absolutely. And the things that wealthy people do are traditional because they are the things that have been in existence since before the tax code was even implemented. 1913 is the beginning of our tax law. That’s not that long ago when you look at the history

[10:38] of humanity. And so things like real estate, things like life insurance, things like drilling for oil, all of those were on the scene long before the tax code was put forth. And so it’s nice because they have their tax benefits, not because of some special tax treatment. They have their tax benefits because it’s the way that they work and the way that they were formed originally. So it’s not like they’re getting special treatment. They just are what they are. Loans, same idea. Loans have never been taxable. Insurance is not taxable. When you get paid car money because you ruined your car in an accident, that’s not a taxable event. That’s how insurance works. And so it’s going to be fun as we continue to go forward. And things like machine learning and artificial

[11:30] intelligence come into play and make insurances even more efficient and continue to cause growth in our society. What is going to happen in these spaces around taxation, especially when so much more can be transparent, so much more can be automated, so much more can be sliced and diced so it’s specific and not just this big gray matter, but super black and white. And I’m looking forward to those aspects of our finances because I think it will make all of us enable our finances to be more efficient while at the same time enable our time to also be more efficient so we can spend more time doing what we love and less time fighting with paperwork. That’s so true. So very true. And I think as we wrap up this episode, a piece that I think of when I’m looking at tax deferred and tax free

[12:29] and I’m trying to figure out what would be the best situations is this. We only have control over the present right now. And we can’t predict what’s going to happen. I don’t know when I’m going to pass away. And I certainly don’t know what the government’s going to be doing in 50 years. I don’t know what they’re going to be doing next year. So what we have to do is focus on our personal economies, ourselves, our families and do the very best that we can with the tools that we have right now. And one of those tools that I find to be helpful is reaching out to knowledgeable people, getting my questions asked, learning as much as I possibly can and continuing to grow. And the days that I stopped doing that,

[13:18] that’s scary. I don’t even want to fathom what that looks like. That should basically be the day that you go six feet under. Yes. There we go. Well, Kim, this was really helpful for our listeners so that you have a basic understanding of tax deferred versus tax free. If you have specific questions and you’re trying to navigate this, reach out to Kim and her team at hello at partnersforprosperity.com and you can ask your question in the subject line or you can have an email in there. And you guys are amazing at answering those. So thank you so much, Kim. And if it’s a listener question you want on the air on the podcast, let us know as well. Sound like a plan? Sounds awesome. Thank you. Thank you for listening to the Prosperity Podcast. To take control of your money and

[14:16] have it work for you, visit us at partnersforprosperity.com. If you liked this episode, make sure you subscribe and leave a review.