“In this world, nothing is certain except death and taxes.”
— Benjamin Franklin
While taxes are inevitable, certain accounts allow you to legally reduce, defer, or eliminate taxes on your savings. These tax-advantaged accounts are powerful tools for building wealth, and understanding them can help you make the most of your financial future.
Overview of Tax-Advantaged Accounts
There are three main types of tax-advantaged accounts, each with distinct tax benefits and limitations:
Tax-Deferred Accounts
- How They Work: Pre-tax contributions are made to the account, and the investments grow tax-free until withdrawal. Taxes are paid upon withdrawal, typically during retirement.
- Examples:
- Pre-tax 401(k)
- Traditional IRA
- Key Benefit: Contributions reduce your taxable income in the current year, potentially placing you in a lower tax bracket.
Roth Accounts
- How They Work: Contributions are made with post-tax dollars. Both your contributions and investment growth can be withdrawn tax-free during retirement.
- Examples:
- Roth 401(k)
- Roth IRA
- Key Benefit: Tax-free withdrawals in retirement, making this account particularly advantageous if you expect to be in a higher tax bracket later in life.
Tax-Free Accounts (Health Savings Accounts)
- How They Work: Contributions are made with pre-tax dollars, grow tax-free, and can be withdrawn tax-free for qualified medical expenses.
- Examples:
- Health Savings Account (HSA)
- Key Benefit: HSAs are often referred to as “triple tax-advantaged” because they offer tax benefits on contributions, growth, and withdrawals.
Contribution Rule of Thumb
One common mistake young professionals make is underutilizing tax-advantaged accounts. When I was at my first job, I was 23. I did not contribute to the company 401k at all; retirement can seem far off, and I felt it too restrictive to locking up money until age 59½. That was a big regret!
When it comes to prioritize contribution to these accounts, I’ve been using the following rule of thumbs. I’m sharing it here for your reference, and you may want to make adjustments for your own scenarios.
Step 1: Get the Employer Match on 401k
Many employers offer a 401(k) match, which is essentially free money. For example, if your employer matches 50% of the first 6% of your salary contributed, ensure you contribute at least 6% to capture the full match.
Step 1.5: Max out HSA contribution
If you have a high-deductible health plan (HDHP), an HSA is a great way to save for future medical expenses while enjoying triple tax benefits. Contributions can also be invested, turning the HSA into a stealth retirement account for healthcare costs.
Step 2: Contribute to the 401(k) IRS Maximum
Once you’ve secured the employer match, aim to contribute up to the annual IRS limit for 401(k) accounts (currently $22,500 for individuals under 50 in 2025). This step maximizes your tax-deferred savings potential.
Step 3: Contribute to an IRA
If Your Employer Provides a 401(k): You may not qualify for a tax deduction on traditional IRA contributions, but you can still use a backdoor Roth IRA to contribute post-tax dollars and enjoy tax-free growth.
If Your Employer Does Not Provide a 401(k): You may qualify for tax-deductible contributions to a traditional IRA, making it an excellent next step.
Step 4: Use the Mega Backdoor Roth 401(k) (If Available)
Some employers allow after-tax contributions to a 401(k), which can be rolled over to a Roth IRA. This is a powerful way to save even more for retirement if you’ve maxed out other options.