What type of dollars are invested in a retirement plan, either tax-deferred or tax-free?

The term "tax-favored dollars" refers to money that is invested in retirement plans with advantageous tax treatments. This can include funds that are either tax-deferred or tax-free, depending on the specific type of retirement account.

In tax-deferred accounts, such as traditional IRAs or 401(k)s, contributions are made before taxes are assessed. This allows the investment to grow without being taxed until withdrawals are made during retirement, potentially at a lower tax rate. In tax-free accounts, such as Roth IRAs, contributions are made with after-tax dollars, but qualified withdrawals—including earnings—are entirely tax-free.

Choosing tax-favored dollars indicates an understanding of how investments can work within the framework of different tax regulations to maximize eventual take-home benefits during retirement. This concept is crucial for effective retirement planning, as it helps individuals retain more of their investment growth over time.