| 401k | HSA | IRA | Total |
|---|---|---|---|
| $69,000 | $4,150 | $7,000 | $80,150 |
You can be saving a lot more money each year in tax-advantaged accounts. Taxes can significantly reduce the gains your investments will make while growing towards retirement, and we'll take a look at some of the accounts available to optimize your retirement savings.
Most people earn more and pay a higher marginal tax rate in their working years than in retirement. By deferring paying income tax during high earning years, and instead pay it during retirement at a lower tax rate, you can save more money.
In taxable investment accounts, you pay capital gains taxes when you sell stocks, and you pay income tax rates on most dividends. Most retirement accounts don't incur taxes on sales or dividends of investments.
There are some situations in which you don't have to pay tax at all on income used to pay for certain health expenses. We'll take a look at some of these cases in the HSA section.
A 401k is a tax-advantaged retirement account managed by your employer. Many people are familiar with the popular pre-tax 401k, but not many people know about the mega backdoor Roth process, which allows you to save up to $69,000 a year total across Roth and Traditional 401k.
In a regular pre-tax 401k, you can contribute up to $23,000 each year. With your employer's contribution of $0, you'll be able to contribute an additional $46,000 via the mega backdoor Roth process.
Alice and Bob both earn $120,000 annually, with a 33.3% marginal tax rate (24% federal + 9.3% state). Alice contributes $19,500 to her 401(k), lowering her taxable income to $100,500 and saving $6,500 in taxes. Bob doesn’t contribute to a 401(k), so his taxable income stays at $120,000, and he pays $6,500 more in taxes. Instead, Bob invests $13,000 in a taxable account, leaving both with the same amount of post-investment cash.
At retirement, both withdraw $50,000. Bob owes $1,500 in taxes from his taxable account, while Alice pays $6,000 in taxes on her 401(k) withdrawal. Despite paying more taxes in retirement, Alice benefits from investing the full $19,500 compared to Bob’s $13,000. Over 30 years at 4% annual growth, Alice’s investment grows to $63,000, while Bob’s grows to $42,000.
Alice ends up over $15,000 ahead, thanks to tax deferral and compounding in her 401(k).
HSAs are tax-advantaged retirement accounts that help people save for medical expenses that high-deductable healthcare plans (HDHP) don't cover. You have to be covered under an HDHP to contribute to a HSA, but it is one of the most tax advantaged accounts available. Unfortunately, the benefits of HSAs don't apply to state taxes in California and New Jersey, but they still retain their benefits for federal taxes in those states.
HSAs are commonly used to pay for qualified health expenses in the year they occur. The hack is that there is no time limit on when expenses occur and when you can withdraw that money tax free.
That means you can pay for your health expense with after-tax money, leave the money in the HSA to continue to grow tax-free, keep the receipt, and then in retirement, you can use those receipts to withdraw from your HSA tax-free. This strategy maximizes the amount of your money you keep in tax-advantaged accounts.
IRAs are tax-advantaged retirement accounts managed by individuals. There are two types of IRAs: Traditional and Roth. You can contribute up to $6,000 a year to an IRA and an additional $1,000 if you are older than 50. If you are married, you can contribute twice that amount between the both of you.
An advantage of a Traditional IRA is that contributions may be tax-deductable, but there is an income limit to who can take advantage. Similarly, there are income limits to who can directly contribute to Roth IRAs.
If your income is greater than the Roth limit, you can still use a Backdoor Roth process. The Backdoor roth is a process that allows anybody to contribute to a Roth IRA regardless of income.