Where you hold investments can matter almost as much as what you hold. In the United States, several account types offer tax advantages for retirement and health savings. Understanding how they differ helps you decide where your next dollar of savings should go. Contribution limits, income limits and other figures change regularly, so check the current numbers on IRS.gov before acting.
Employer plans: the 401(k) and similar accounts
A 401(k) is a workplace retirement plan offered by many private employers; 403(b) and 457(b) plans serve similar roles for nonprofit and government workers. Contributions are made through payroll.
- Traditional contributions are generally made before income tax. Investments grow tax-deferred, and withdrawals in retirement are taxed as ordinary income.
- Roth contributions, where the plan offers them, are made after tax. Qualified withdrawals, including earnings, can be tax-free if the plan's rules are met.
- Employer matching: many employers match part of employee contributions. Matching contributions may be subject to a vesting schedule, and not contributing enough to receive the full match means leaving part of your compensation unused.
- Investment menu: you choose from the funds the plan offers, so it is worth reviewing their fees.
Individual retirement accounts (IRAs)
An IRA is opened by the individual at a bank, brokerage or other provider, usually with a much wider choice of investments than an employer plan.
Traditional IRA
Contributions may be tax-deductible depending on your income and whether you or your spouse are covered by a workplace plan. Growth is tax-deferred, and withdrawals are generally taxed as ordinary income.
Roth IRA
Contributions are made with after-tax money and are not deductible. Qualified withdrawals of earnings can be tax-free once you meet the age and holding-period rules. Eligibility to contribute directly is phased out at higher income levels.
Rollovers
When you leave a job, you can often move a 401(k) balance into an IRA or a new employer's plan. A direct rollover between providers generally avoids withholding and the risk of missing deadlines.
Health savings accounts (HSAs)
An HSA is available only to people covered by a qualifying high-deductible health plan. It offers three potential tax benefits: contributions can be pre-tax or deductible, growth is not taxed, and withdrawals used for qualified medical expenses are tax-free. Unused balances roll over from year to year, and many providers allow the money to be invested. Withdrawals for non-medical purposes are taxed and, before a certain age, may also face a penalty.
Rules that apply across accounts
- Early withdrawals: taking money from retirement accounts before the eligible age usually triggers income tax and an additional penalty, with some exceptions.
- Required minimum distributions: traditional accounts generally require withdrawals to begin at a certain age; Roth IRAs do not require them during the original owner's lifetime.
- Beneficiaries: keep beneficiary designations up to date, because they usually override instructions in a will.
Traditional or Roth?
The choice often comes down to whether you expect your tax rate to be higher now or in retirement. Traditional contributions reduce taxes today; Roth contributions can reduce taxes later. Many savers split contributions between both to diversify their future tax treatment, especially when the future is uncertain.
A common order of priorities
A frequently discussed approach is to build an emergency fund first, contribute enough to an employer plan to receive any full match, consider an HSA if eligible, then fund an IRA or additional workplace contributions. Your situation, including debts, income and goals, may call for a different order.
This article is general educational information, not investment, tax or legal advice, and it is not a recommendation to buy or sell any security. KazimirInvestmentsLLC.com does not provide investment advisory or management services. Check current rules with official sources such as Investor.gov, the SEC, FINRA or the IRS, or consult a licensed professional.