Tax-advantaged accounts 101

An overview of the accounts that escape income taxes

As we described in our overview on stock taxation, taxes on investments (especially dividends!) can add up. To incentivize people to invest for their future, the government has provided tax incentives to save for retirement and college. There are two primary account types the government supports with tax incentives — tax-free and tax-deferred accounts.

Tax-free accounts

Tax-free accounts are accounts you invest in with what’s called “post-tax money” — money you’ve already paid taxes on, like what’s in your bank account.

The tax advantage comes into play after you invest:

  • In these accounts, no investment taxes are incurred on your investments. Dividends and income from your investments in those accounts aren’t taxed. Neither are capital gains when you sell assets in those accounts.

However, these accounts typically come with restrictions onhow much you can contribute and when you can withdraw funds.


  • Roth IRA/Roth 401(k):
    • Intended for retirement.
    • Limitations on withdrawals (except for various hardship cases) until 60, where some types of withdrawals may incur a financial penalty.
    • Income limit present, though “backdoor” mostly bypasses this.
  • 529 plan
    • Intended for saving for college.
    • Withdraws only for college expenses — financial penalty otherwise
    • Some states offer state income tax deductions on contributions.

Tax-deferred accounts

aka pre-tax retirement accounts

They are similar to tax-free accounts where no explicit dividend or capital gain taxes are incurred on your investments.

However, they have an added twist where they also defer taxes.

  • contributions deducted from contributing year’s taxable income (i.e. you invest “pre-tax money”) - so you avoid paying federal and possibly state taxes on the contributions.
    • Sometimes these contributions are handled by your employer (401k, HSA), becoming deductions from your paycheck.
  • When you withdraw, the withdrawal is added to withdrawal year’s taxable income.

If your tax rate is lower in the future than today, this tax deferral is an added bonus!

They also come with various contribution restrictions and withdrawal restrictions.


  • IRA
    • Intended for retirement.
    • No withdrawals (except for various hardship cases) until age 60 — financial penalty otherwise.
    • 2019 contribution limit is $6000/person.
    • Generally you cannot use these if your employer offers a 401(k). (you can’t deduct the contribution)
    • Once you are 70, you are required to withdraw a certain amount every year (the “Required Minimum Distribution” (RMD)).
  • 401(k): Effectively an Employer sponsored IRA
    • 2019 contribution limit is $19,000 (+ employer matching)
  • HSA: Health Savings Account
    • If you have a high-deductible health plan, can contribute up to $3,500 ($7,000 married) to these accounts.
    • Withdrawals are tax-free to pay for health care expenses. (meaning you don’t just defer taxes, you eliminate them!)
    • However, you can also withdraw for non-health-care expenses, similar to an IRA, once you are 65. In contrast to an IRA, there are no RMDs!
    • Any other withdrawal incurs a financial penalty.

General strategies


  • Before retirement, if you can afford to save the money, max out all contributions to every tax-advantaged account — your work’s 401K, an IRA or a Roth IRA, an HSA.
    • If you can’t afford to max out everything, first put money in tax-deferred before tax-free, as generally, your tax rate in retirement will be lower than today’s.
  • If you have kids or plan to have them, and plan to fund some of their education (private school or college), it may be wise to make 529 contributions.


  • If you are in a relatively low tax bracket (retired early, taking a sabbatical), convert your 401k into a Roth.
    • A roth is more valuable than a 401k because you don’t need to pay any taxes at withdrawal.

Asset allocation

When you have investments in these different accounts, it turns out that you want to put different assets into each. For example, if you wish to own assets that produce high amounts of ordinary income (bonds, REITS), it’s best to put these first in your tax-advantaged accounts before adding more “tax-efficient” assets (e.g. stocks that pay little qualified dividends)

If you’re interested in details, read tax-efficient fund placement by Bogleheads for more information. We might provide some guidance in this area in the future.


Generally drawdown from least valuable account to most:

  • Taxable - you are paying dividend taxes and capital gains taxes
  • Tax-deferred - you are paying taxes on withdrawals (analogous to capital gains)
  • Tax-free - no taxes on investments

This is a bit simplified; if you understand subtleties of changing tax-brackets, you can do better with a blend. This may be a future AMAF calculator!