27—Lever #2: Taxes (Part Five—Retirement Account Tax Benefits)
For the most tax savings, choose your accounts wisely
Have you ever wondered why the government offers tax credits and deductions for some things and not others? The simple answer is that it provides tax incentives to promote its goals.
Due to the demise of pensions, the government wants to incentivize taxpayers to save for retirement using individual retirement savings accounts like IRAs and employer plans like 401(k)s. And when they wanted you to buy an electric car instead of gas, they gave you a green energy credit to help with the purchase. I think you get the picture.
The best reason for having a basic understanding of the tax code is to use it to lower your average tax rate (total taxes you pay divided by your gross income) and your lifetime tax rate (amount of taxes you pay over your lifetime as a percentage of your total income).
Remember our Financial Life Equation (how could you forget?):
We’re now focused on the “minus sum of all taxes paid” (– ∑Tt+n ) component and want to minimize that number.
In the last article, we saw how specific retirement account contributions reduce your gross income for tax purposes. This article will delve deeper into the different types of accounts you can use for your investments and how they are taxed.
Consider each type of account as an empty container you can fill with your investments. The U.S. government treats each investment differently regarding how it taxes them. Thus, understanding those differences and planning how you will use them can significantly impact how much tax you pay.
Let's start by defining some important terms:
Retirement accounts are intended to hold assets invested for the long term and typically receive favorable tax treatment from the IRS.
Employer retirement plans include a variety of retirement accounts but are typically 401, 403, or 457-type plans. (Smaller companies may offer a SIMPLE IRA or SEP.) These also include defined benefit plans, known as "pensions," but are increasingly rare.
Before-tax money goes into your account before you pay any taxes (reduces gross income and taxable income).
After-tax money goes into your account after you have paid taxes on it (does not reduce gross or taxable income).
Taxable investments are taxable—both income and growth. They are typically in a taxable brokerage account.
Tax-deferred investments grow tax-free until you withdraw them. These include the Traditional 401k, Traditional 401a, Traditional 403b, Traditional 457, and Traditional IRA. (When you see the word "Traditional,” it usually means not Roth.)
Tax-exempt investments grow tax-free and can be withdrawn tax-free. These include the Roth 401k, Roth 401a, Roth 403b, Roth 457, Roth IRA, and 529 (college savings). A Health Savings Account (HSA) is also tax-exempt.
Now, take a look at this table. It shows how the different types of retirement accounts are taxed.
Some of these are better than others relative to how (and when) they are taxed. For example, an HSA is the most advantageous due to its “triple tax advantage." That is because 1) contributions are not taxed, 2) dividends and capital gains are not taxed, and 3) withdrawals are not taxed. Boom!
Plus, if you make HSA contributions through your employer, they are pre-tax, including payroll taxes (Social Security and Medicare).
Roth (tax-exempt) accounts aren’t too shabby either—contributions are taxed, but interest and capital gains are not, and neither are withdrawals made later on in retirement.
Traditional (tax-deferred) accounts are next—contributions are tax-free and grow tax-deferred but are taxable upon withdrawal.
Taxable brokerage accounts are less tax-favored than the others as they are taxed all along the way. However, there are things you can do to lower your tax burden in those accounts.
For many of you, it may make sense to contribute to them in this order:
1) HSA
2) Traditional or Roth
3) Taxable brokerage.
I recommend contributing to an HSA and at least enough to a 401(k)-type account to get your employer’s matching contribution.
But that changes if you can't contribute to an HSA pre-tax through your employer. In that case, start with your 401(k) at work. Contribute enough to get the free match at a minimum, and if it's in your plan, consider contributing as a Roth (after-tax). If you want to contribute more, do so in an IRA.
Here’s an example of what this might look like for someone with an income of $60,000 who wants to save 12% of their income in 2025:
Once you decide to contribute, you must put the money in a Roth (after tax) or a Traditional account (before tax). The goal is to be strategic about how and when you contribute to save the most on taxes over your lifetime.
This is probably an over-simplification (I'll do a deeper dive on this in the next article), but here are some general rules you can follow based on your marginal tax bracket and the current tax code:
Low brackets: 10%, 12% => Roth contributions
Medium brackets: 22%, 24% => A mix of Roth and pre-tax
High brackets: 32%, 35%, 37% => Pre-tax contributions
The benefit of Roth contributions (post-tax) when you are in a lower marginal bracket is that you're likely to be in a higher one later on and perhaps even in retirement. You are paying less tax today (on a percentage basis) than you might in the future.
The other significant benefit of a Roth is that your money grows tax-free forever. Since you have already paid taxes, your money is removed from the tax system for all eternity.
The benefit of making traditional contributions (pre-tax) when you are in higher marginal brackets is taking the deduction for more tax savings today in return for paying less tax in the future when you might be in a lower bracket. Your money will grow tax-free in a traditional account but won't be tax-free forever. You'll have to pay taxes when you withdraw from the account.
Anybody who has reached the 32%, 35%, or 37% tax bracket should probably be making pre-tax contributions.
Which is best for you depends on your current situation and where you think taxes will be in the future. This is an important difference and decision. You have the same options when you open an IRA account. Most professionals say go with the Roth option when in doubt (or if it's a tie).
I was thinking about this and my situation as a retiree because I have sometimes regretted focusing too much on minimizing taxes while working and not building up tax-exempt income sources, such as Roth accounts, for retirement. (However, I wasn’t income-eligible to contribute to a Roth for many years.)
My perspective on this changed when I looked at my back tax returns. The actual marginal rates based on my taxable income for the 15 years before I retired were all higher than my current marginal rate in retirement.
And perhaps more importantly, my average (effective) tax rate is much lower in retirement than my marginal rate while I was working, which may be a better way to think about this. Admittedly, this is partially due to lower tax brackets since the Tax Reduction Act of 2017, and tax brackets could be higher in the future. But even if they doubled, my average tax as a retiree would still be less than my marginal rate while I was working. So, as it turned out, I would not have been better off putting money into Roth accounts after all.
One thing to remember about taxes is that the tax code changes almost every year, and tax rates can go up or down based on inflation and the prevailing political winds. So stay vigilant and be prepared to pivot when necessary.
For reflection: Do you ever think about your “future self”? What do you think he or she would say to your present self about planning for the future? The Bible tells us to “number our days that we might gain a heart of wisdom” (Psalm 90:12). That implies that it can be foolish to only live (and spend) for today. Are you taking advantage of the retirement savings accounts available to you, even if it’s making relatively small contributions? If not, what would your future self say?
Verse: “Precious treasure and oil are in a wise man’s dwelling, but a foolish man devours it” (Proverbs 21:20, ESV).