Tax Advantaged Accounts

Last updated April 2, 2023

This page gives an overview of the various tax advantaged accounts that anyone with some disposable income should know about and consider opening or contributing to so their money can go a little further towards future savings.

Income Taxes

Income taxes are generally assessed either:

Understanding the above concepts is important for understanding the benefits of tax advantaged accounts.

Tax Advantaged Accounts

Certain types of savings accounts are known as “tax-advantaged”, which means they allow you to avoid paying the income taxes in one or more of the cases listed in the previous section.

There are four main types of tax-advantaged accounts that are relevant for most in the workforce, and this document will give an overview of each: 401k (retirement), IRA (retirement), HSA (healthcare), and 529 (education).

401k is an employer-sponsored retirement plan. Some employers don’t offer a 401k, and may instead offer some alternate retirment plan. If the employer does not offer any retirement plan, the employee may be able to individually open an alternative, for example an SEP-IRA.

Retirement Accounts

Tax advantaged accounts allow you to skip paying taxes in one or both of the cases listed above. In the case of both types of retirement accounts (401k and IRA), you get to choose which tax advantage you want. These options are “Traditional” and “Roth”. Regardless of which kind of 401k you choose, many employers offer an employer match, so they’ll match the first X% of your paycheck that you contribute to your 401k. This is just free money, so make sure you take advantage of it!

Traditional 401k/IRA

In a Traditional 401k/IRA, you can make “tax deferred” contributions, meaning you don’t have to pay taxes when you get that money, instead you put it straight into the retirement account and only pay taxes on the gains when you take the money out.

In the case of a Traditional 401k, that money is typically contributed straight from your paycheck before taxes. Because those contributions are made “pre-tax”, they reduce your taxable income, so if you were making $100,000 and decided to max out your 401k ($20,500 limit in 2022), instead of paying taxes on the full $100,000 (Which would be $17,835.50 in taxes in 2022) you would instead pay taxes only on the remaining $79,500 (Which would be $13,107 in taxes in 2022), so by maxing out the Traditional 401k you can avoid having to pay $4,728.50 in taxes. Of course, because it’s in a retirement account that money is now subject to restrictions on what it can be used for, so be sure you don’t need it for something else before doing that.

With the Traditional 401k, that money will still be taxed as normal income when you take your distributions from it in retirement. However, assuming your income is lower when in retirement than it was during your working years (likely), you are likely to be in a lower tax bracket which would mean a lower percentage of that money would be taxed. Effectively, we’re taking some of the taxable income we had during our high-earning years and moving it to our low-earning years, thus smoothing out our earnings rate over the course of our lifetime, which should theoretically reduce the total amount we pay in taxes over our lifetime. This is in line with the tax burden reduction philosophy described here.

Roth 401k/IRA

In a Roth 401k/IRA, you pay the taxes up front, but the gains are tax-free. So once you’ve contributed to the Roth 401k or IRA, you never need to worry about taxes on that money again. This can be really powerful, especially if you are expecting that money to grow significantly over the course of your lifetime.

If you were making $100,000 and you decided to max out your Roth 401k, you’d pay taxes on the full amount, ($17,835.50 in taxes in 2022) and then could contribute up to $20,500. We’re intentionally paying the extra $4,728.50 in taxes that the Traditional 401k would let us avoid, because we believe we’ll make up for it later in life by not having to pay taxes on the capital gains.

For example, if that $20,500 grew to $50,000 by the time we retired, with a traditional 401k we’d still need to pay taxes on that money. Assume (with a traditional 401k) we took that money out slowly, no more than $10,275 per year to keep us in the lowest tax bracket (10%). We would pay $5,000 in taxes over the course of those distributions, which is more than the $4,728.50 we avoided paying originally! Alternatively, with the Roth 401k, we’d be able to take that $50,000 out at any rate we needed it, without needing to worry about paying any taxes on it.

Of course, there are lots of factors that could impact the effectiveness of the Roth 401k. The amount the money is likely to grow is a huge factor; if that money grew only to $25,000 or $30,000 it would be a very different story! Additionally, tax brackets may change over our lifetime. Taxes may go up or down. If taxes go up, then the Roth may be a better choice because we “locked in” paying when the taxes were lower. Alternatively, if the taxes go down, then the Traditional may have been a better choice because we waited to pay taxes until there were lower rates.

Which should I choose?

There is no clear choice of which is better, but it may be a good idea to hedge our bets and choose one of each. Many people like to choose a Traditional 401k and a Roth IRA, so they have both options available to them. This gives them flexibility in retirement: If this year is a high-income year, they can choose to take more money out of the Roth IRA and less from the Traditional 401k so less of their money is subject to taxes. Alternatively, if (as most retirement years are likely to be) it’s a lower-income year, they can take more of their money from the Traditional 401k since their tax rate will be relatively low.

Additionally, there is nothing preventing you from having both or switching later. You can hold both types of accounts simultaneously and change whether you are contributing to a Traditional or a Roth each year (or do some contributions to Traditional and others to Roth), as long as the total contributions between them does not exceed the 401k and IRA contribution limits.

IRA specifics

IRA stands for Individual Retirement Account. The options for IRAs are the same as the options for a 401k, Traditional and Roth. However, an IRA has contribution constraints that the 401k does not. It has a separate, much lower contribution limit than the 401k ($6,000 compared to $20,500 in 2022), and it’s opened individually rather than through your employer. Money you contribute to an IRA must be earned that calendar year, so you can’t contribute to one if you don’t have any taxable income.

Additionally, the IRA has income limits that complicate the contribution process. There are separate income constraints for each of the Traditional and Roth IRAs.

Traditional: If you have a 401k plan and your income is above $78,000 (in 2022), then your contributions to a Traditional IRA are non-deductible. This effectively eliminates the benefit offered by the Traditional IRA, because the reason to use it would be to lower your taxable income by deducting that contribution from your total income.

Roth: If your income is in the $129,000 - $144,000 range (for 2022), then it’s subject to a phase-out, meaning the amount you can contribute to the Roth IRA is some amount less than the full $6,000 that year. Refer to the IRS website to see the exact amount you can contribute. With income above $144,000, you are not allowed to contribute to a Roth IRA.

So, what if you make more than $144,000? You’re not allowed to contribute to a Roth IRA and you’re ineligible for the benefits of a Traditional IRA. At this point, the way to benefit from an IRA is to utilize the inconvenient and confusing but well documented backdoor Roth IRA conversion approach.

Backdoor Roth IRA conversion

Effectively, the backdoor Roth IRA conversion allows you to contribute to a Roth IRA with all the same benefits regardless of your income level.

To perform a backdoor Roth IRA conversion, first you must contribute to your Traditional IRA, then perform a backdoor Roth IRA conversion to move the money to your Roth IRA. The effect is the same as if you had contributed directly to your Roth IRA, but the tax paperwork is more complicated: You pay income taxes on the money that year, then the money is in the Roth IRA and can grow tax free. The white coat investor gives a good overview of the process and caveats.

The only thing to be wary of with the backdoor conversion process is the “Pro Rata” rule. If you end the calendar year with more than $0 in your Traditional IRA, then you incur additional taxes when you perform the backdoor Roth IRA conversion. If you already have a Traditional IRA with some contributions in it, you can convert all of it to a Roth IRA (incurring some taxes), but then for future years you will be able to perform the backdoor conversion without much trouble.

Health Savings Accounts (HSAs)

HSAs are even more tax-advantaged than 401ks and IRAs, because you can contribute pre-tax AND don’t have to pay taxes on gains. It’s completely tax-free all the way through. The only requirement is that you must be enrolled in a high deductible health care plan. The contribution limit is $3,850 (2022) and that the money taken out needs to be used for healthcare related expenses or it will incur additional taxes.

Because HSAs are so tax advantaged, they are a great long-term savings vehicle. It can be advantageous to use the HSA as an investment account and pay your healthcare bills out of pocket to give the tax advantaged money in the HSA more time to grow and compound before you start to draw from it.

Some HSAs do charge fees, but not all do. Frequently, your employer will cover the fees associated with an HSA, but if not, or if you change employers you may then find yourself on the hook for those fees. In that case, it may be worth shopping around for a provider that doesn’t charge fees. You should be able to transfer money between the accounts without tax implications, though they may still charge fees to do so. This page gives a good overview of HSA fees to watch out for.

Additionally, some employers will contribute some amount to your HSA each year. Check for this and make sure to take advantage of the free money!

529 Plans

529 plans are tax advantaged accounts specifically designed to be used for education related expenses. Similar to a Roth 401k or IRA, you pay the taxes up front, but gains are tax-free. This makes them especially powerful as long-term investment vehicles, because gains will have a longer time to compound.

When you open a 529 plan, you designate a beneficiary. Usually, that is a child or grandchild, but you can also designate yourself. There is no annual contribution limit to a 529 plan, though if the beneficiary is someone other than yourself then the contributions are considered gifts and so must be $16,000 or less in 2022 or be subject to the gift tax. 529s do have a unique constraint however: there is an aggregate contribution limit. These limits range from $235,000-$550,000 (depending on which state you open your 529 plan with). No contributions may be made that would increase the value beyond the aggregate contribution limit. However, the account value can continue to grow beyond that limit if the holdings increase in value.

529 plans are unlikely to be useful for yourself unless you plan to go back to school, but they can be a useful vehicle for passing wealth on to future generations and relatives, as the beneficiary of the account can be easily changed with no tax implications, and ownership of the account may also be transferred, though only once a year.

What next?

Once you’ve added money to a tax-advantaged account, next you should decide how to invest it so it grows over time. Fortunately, all the types of tax-advantaged accounts discussed above offer the ability to invest that money while it’s in the account. Depending on the institution that administers the account, the specific funds/investment options available to you may vary, but all should have some reasonable choices to let your money grow. Visit the investing page for an overview of what to consider when deciding where to invest your money.