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
types the government supports with tax incentives — tax-free and tax-deferred accounts.
Tax-free accounts are accounts you invest in with what’s called “post-tax money” — money you’ve
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
investments in those accounts aren’t taxed. Neither are capital gains when you sell assets in
However, these accounts typically come with restrictions onhow much you can contribute and when you
- Roth IRA/Roth 401(k):
- Intended for retirement.
- Limitations on withdrawals (except for various hardship cases) until 60, where some
- 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.
aka pre-tax retirement accounts
They are similar to tax-free accounts where no explicit dividend or capital gain taxes are incurred
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
- 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.
- Intended for retirement.
- No withdrawals (except for various hardship cases) until age 60 — financial penalty
- 2019 contribution limit is $6000/person.
- Generally you cannot use these if your employer offers a 401(k). (you can’t deduct the
- Once you are 70, you are required to withdraw a certain amount every year (the “Required
- 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)
- Withdrawals are tax-free to pay for health care expenses. (meaning you don’t just defer
- 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.
- Before retirement, if you can afford to save the money, max out all contributions to every
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
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
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
pay little qualified dividends)
If you’re interested in details, read tax-efficient fund
by Bogleheads for more information. We might provide some guidance in this area in the
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!