How to Reduce Your Taxes While Investing for Retirement
Don't pay more taxes than you have to.
Anyone can open a brokerage account and start investing in stocks, bonds, mutual funds or ETFs. A brokerage account can be great if you don’t know what you’re investing for or what your time horizon is. But by introducing tax-advantaged retirement accounts to your investing strategy, you can save an incredible amount on taxes over the course of your working career and beyond. They basically work like this: In exchange for following certain rules about how much you can put into these accounts and when you can access your money, you get a tax break.
There are generally two kinds of tax treatments you’ll see in these accounts: Pre-tax, or tax-deferred, and after-tax.
Pre-Tax Accounts
In a pre-tax account, your contributions reduce your taxable income in the same year you make them. You will still owe taxes on the money you put into the account and any growth you see in your account balance, but you get to defer paying these taxes until you retire and begin withdrawals.
For example, let’s say you have a taxable income of $50,000 and you contribute $6,000 to a pre-tax retirement account. Your taxable income is now reduced to $44,000. You can invest your contributions and they will grow tax-free, but whatever you take out in retirement becomes taxable income.
After-Tax Accounts
After-tax accounts don’t give you a tax break in the year you contribute to them. So if you have a taxable income of $50,000 and you contribute $6,000 to an after-tax account, your taxable income will still be $50,000.
But there are great tax benefits that come over the long term. After you contribute and invest the money, your account will grow tax-free forever, and as long as you meet the requirements for withdrawals, they will be tax-free too. This makes these accounts advantageous for younger workers who likely fall into a lower tax bracket than they will in the future. It also benefits workers today if tax rates rise by the time they retire. And with today’s low tax rates, this may be a reasonable assumption to make. Contributing to an after-tax account lets you lock in your tax payment now.
You can generally start withdrawals at age 59.5, but there are exceptions depending on your circumstances and the type of account. Withdrawals before that age are often subject to additional taxes and penalties.
There are two ways you can get access to a retirement account: By working for an employer that offers them or by opening one on your own. Both kinds offer potential benefits, and they can be used in tandem.
The following list isn’t meant to be exhaustive but to provide a brief overview of account types that will be relevant to the majority of U.S. investors and how they receive tax treatment.
Employer-Sponsored Accounts
In order to qualify for one of these accounts, your employer must provide them.
401(k)
When most people think of a retirement account, they might think about the 401(k). It’s one of the most common ways American workers save for retirement. Companies have been replacing their pension plans with 401(k)s since the late 1970s when they were introduced.
With a 401(k), you can defer up to $19,500 of your salary and an extra catch-up contribution of $6,500 if you’re over the age of 50. A 401(k) offers a menu of investment options. Some plans feature low-cost index funds, while others are loaded with high-fee, actively managed funds.
An employer may also provide matching contributions. For example, if an employer matches up to 3% of an employee's salary, then an employee earning $50,000 a year before taxes can put in 3% of their salary, or $1,500, and their employer will match that contribution with $1,500. Many employers have vesting rules, such as a requirement that you stay employed at your company for a set period of time before those matching contributions are actually yours. Some employers are more generous with their matching contributions, while others don’t offer them at all.
The total combined cap for employee and employer contributions is $58,000 for 2021, or $64,500 if you’re over 50. High-income earners can put away a staggering amount of money into a 401(k).
Many employers are increasingly offering Roth 401(k)s, which are after-tax versions of the 401(k). These have the same contribution limits and let you pay taxes now in exchange for future tax-free growth and withdrawals.
403(b)
A 403(b) is similar to a 401(k) but offered to employees in education and the nonprofit sector. The contribution limits are the same, and there may be a Roth option available. Generally, 403(b) plans feature poorer investment options than a 401(k), and can be a bit more complex. Still, many have decent index fund options.
SEP-IRA
A SEP-IRA is simpler and cheaper for businesses to maintain than a 401(k) plan. This makes them an attractive option for companies with only a handful of employees that want to keep costs low. It’s exclusively employer-funded, so there’s no ability for employees to contribute money to the account. Your employer must contribute the same percentage of your earnings as any other employee, up to 25% of your salary with a maximum cap of $58,000 for 2021. There is no Roth option, so all money and growth in a SEP-IRA will be taxed in retirement.
If you work as a freelancer or a solo business owner, you are considered both the employee and employer, so you can open a 401(k) or a SEP-IRA on your own.
Self-Managed Accounts
These are accounts you can open yourself, regardless of whether your employer provides a retirement plan. You generally have much more freedom to invest in these accounts. You get to decide where to hold them, meaning you can choose brokerage firms that charge the lowest fees. As long as you have earned income from a job, you can contribute to one of these accounts.
IRA
An Individual Retirement Account (IRA) is a pre-tax account, meaning you can get a tax deduction for your contributions similar to a 401(k). The contribution limits are $6,000 for 2021, with a $1,000 catch-up contribution if you’re over the age of 50.
During your working career, account growth will not be taxed. When you retire, you will owe taxes on withdrawals according to your tax rate.
Roth IRA
The Roth IRA was introduced in 1998, and is named after the senator who created them, William Roth. As an after-tax account, you don’t receive a tax deduction for contributions, but you get to enjoy tax-free status after that. Like the Roth 401(k), this makes the Roth IRA attractive for younger workers who are in a low tax bracket. Contribution limits are $6,000 for 2021, with a $1,000 50+ catch-up contribution.
One great feature of the Roth IRA is that because you’ve already paid tax on contributions, you can withdraw them at any time, tax- and penalty-free. This makes it a great option for someone who’s wary of locking up their money for so many years. So if you’ve maxed out your account for 10 years, you can take out $60,000 and put it toward a house, education, another investment opportunity or whatever you like.
The Health Savings Account: A Hybrid Account
The Health Savings Account (HSA) is unique among investment accounts. First, it’s not strictly a retirement account, but it can be used as one. It is the only account that offers a triple tax advantage. Money that you contribute is tax-free, your money may be invested and grow tax-free, and as long as you withdraw the money to pay for qualified medical expenses, you won’t owe taxes. You also aren’t bound to use it only after a certain age. Anyone can contribute money and spend or invest it as they please.
You can open an HSA on your own or use one sponsored by your employer. The only requirement is that you have a high deductible health care plan.
Contribution limits are $3,600 for individuals and $7,200 if you have a family health insurance plan. Employer contributions are allowed, but you’re still bound to the same overall limits.
When you reach 65, you can start treating the account as if it were a traditional IRA and pay for non-health expenses as long as you pay income tax on the amount. And you can still withdraw money tax-free for health expenses. This makes the HSA a hybrid account and an awesome tool for building wealth.
Conclusion
Which accounts you should use to invest depends on your situation, goals and your current tax rate. Those who are in a low tax bracket, especially younger workers, may benefit more from after-tax, or Roth, accounts. If you have a higher income today and you expect to have a lower income in retirement, you will probably benefit more from a pre-tax, or tax-deferred, account.
Everyone may benefit from a mix of both. Getting exposure to all three tax treatments across your entire investment portfolio — pre-tax, after-tax and taxable — gives you flexibility.
These tax-advantaged accounts are amazing wealth-building tools that every investor should be using. A committed investor with an income that allows it could put away $19,500 in their workplace 401(k), $6,000 in a Roth IRA, and $7,200 in an HSA. That’s $32,700 in tax-advantaged accounts. Most workers will never be able to put that much away, but the opportunities to invest and reduce your taxes are incredible. It’s a no-brainer to be taking advantage of these accounts as you think about investing for retirement.