What's the Difference Between Tax-Deferred and Tax-Exempt?

Tax-deferred and tax-exempt are both ways to shelter money from taxes, but they work at very different times. With a tax-deferred account like a traditional IRA or 401(k), you postpone paying taxes until later — contributions may reduce your taxable income now, but you'll owe income tax on the money when you withdraw it in retirement. With a tax-exempt account like a Roth IRA or Roth 401(k), you pay taxes on the money upfront, and then qualified withdrawals in retirement are completely free of tax. Municipal bonds are another example of tax-exempt income — the interest is exempt from federal tax and often state tax too, which is why they typically pay lower rates than taxable bonds. The better choice depends on whether you expect to be in a higher or lower tax bracket when you eventually access the money.