Paying taxes in retirement can be a pain, and while there’s no way to avoid them entirely, you can use certain tax-advantaged accounts to lighten the blow. Individual Retirement Accounts (IRAs) and 401(k) accounts are two of the primary vehicles used for tax breaks on savings, but they come in a couple of different flavors, and the rules for contributions and withdrawals can be confusing. 

Many Americans are woefully unprepared for retirement, so it's important to understand how these accounts work and choose the best plan for your nest egg. Today, you’ll learn the rules of each account type, why the Roth variation matters, and how to start retirement planning while minimizing your obligation to Uncle Sam.

Traditional IRAs

The traditional IRA is one of the most effortless retirement accounts to open and offers many investment options. However, contributions are limited, and if you have an employer-sponsored plan, the tax benefit only applies if your income falls under a certain threshold.

Traditional IRA contributions are tax-deferred, meaning the money you put in the account can be deducted from your annual tax bill. But these taxes aren’t canceled; they are only deferred. You’ll pay taxes on your contributions (and capital gains on investment growth) when you withdraw in retirement — when you will theoretically be in a lower tax bracket.

Contribution Limits

You can make a full tax deduction on your traditional IRA contributions if you don’t have a retirement plan like a 401(k) account at your workplace. But you can’t just pack your account with every available dollar like a hibernating bear; the IRS sets annual contribution limits for all tax-advantaged retirement accounts.

Traditional IRA contribution limits change each year, but the rules for 2024 are:

• $7,000 for people aged 49 and under
• $8,000 for people aged 50 and over (the extra $1,000 is known as a "catchup contribution")

Or:

• Your 2024 taxable income if it’s less than $7,000

The last bullet can be confusing, so here’s an example: If you only reported $6,000 worth of taxable income in 2024, that’s also your annual contribution limit. If you only reported $500 in 2024, you can only contribute $500. The penalties for excess contributions can be stiff, so make sure you know your limit each year.

If you or your spouse are covered by a workplace retirement plan like a 401(k) account, your tax deduction will be phased out once your income reaches a certain level. Review the following tables to see if your contributions can be deducted if you have a workplace plan.

Here are the income limits for single filters:

And the income limits for those married filing jointly:

Withdrawals

If you try to withdraw from your traditional IRA before age 59.5, you’ll suffer a 10% penalty in addition to any taxes. There are certain exceptions to this rule (first-time homebuyers, college costs, disability), but most savers will need to keep their money in the account until six months after their 59th birthday.

After age 59.5, you can withdraw as you wish, but drawing down retirement accounts requires careful tax planning. You’ll owe income tax on your contributions and capital gains taxes on any investment growth.

Once you reach age 73, the plot twists again with Required Minimum Distributions (RMDs). At this point, you must withdraw a certain percentage from your account each year, and the amount varies depending on your age and account balance. Again, tax planning is crucial when drawing down retirement accounts, so always consult with an advisor when you hit withdrawal age.

Investing Options

Traditional IRAs have a wide range of investment options available. Unlike most workplace retirement plans, an IRA is a self-directed vehicle, and you can invest in almost any asset your broker offers. IRA investments can include:

• Stocks
• Bonds
• Exchange-traded funds (ETFs)
• Mutual funds
• Annuities
• Certificates of Deposits (CDs)

Certain assets like collectibles and real estate cannot be held in an IRA, but some brokers allow for derivatives like options. You’ll need to check with the brokerage hosting your account and ensure you have proper permission to trade derivatives. Also, remember that IRAs are retirement accounts meant for steady investment growth over time, not quick gains from derivatives. 

Roth IRAs

Roth IRAs are similar to traditional ones but with a few key distinctions. You’ll need to use after-tax dollars to fund a Roth IRA, and you won’t be able to open one if your income exceeds a specific limit (although there is a backdoor option). However, Roth IRAs have several unique advantages all investors should know.

Contribution Limits

Traditional and Roth IRA contribution limits are the same: $7,000 annually, plus an extra $1,000 if you’re 50 or older. But there’s a crucial difference in that Roth IRA contributions are NOT tax deductible. You can only contribute post-tax dollars to a Roth IRA, but the benefit is that all asset growth in the account is free of taxation as long as you take qualified distributions. 

Tax-free investment growth is a tremendous perk, so the IRS limits who can open and fund a Roth IRA. Here are the income limits for single filters:

And the income limits for those married filing jointly:

You can open as many Roth IRAs as you want, but you can only contribute up to your limit across all traditional AND Roth IRA accounts. Be sure to keep check of your contributions across all accounts, and use tools like MarketBeat’s Roth IRA calculator to ensure you’re on track with your goals.

Withdrawals

At withdrawal, Roth IRAs shine as a beacon of efficiency. Although you cannot withdraw any investment growth before age 59.5 without tax or penalty, because your contributions are made with after-tax dollars, you can withdraw your basis anytime, provided you’ve had the account open for at least five years.

After age 59.5, you can withdraw from a Roth IRA with no limits or minimums. And here’s another perk - no RMDs! Drawing down a Roth IRA is entirely on your terms and schedule as long as you’ve reached the qualified distribution age and held the account for five years.

Like the traditional variety, Roth IRAs have some withdrawal exceptions for first-time homebuyers, qualified education expenses, and certain health considerations. If you plan to use your Roth IRA for something other than retirement, check with your advisor first. 

Investing Options

You have the same investment selections in a Roth IRA as a traditional one:

• Stocks
• Bonds
• Exchange-traded funds (ETFs)
• Mutual funds
• Annuities
• Certificates of Deposits (CDs)

While you can invest in similar assets, traditional and Roth IRAs have different tax benefits, so your asset allocation should vary. For example, you might put dividend-paying stocks in a Roth IRA and growth stocks for long-term holding in a traditional IRA. Your dividends won’t be taxed in the Roth regardless of how long you hold the underlying stocks, and you’ll pay the more beneficial long-term capital gains rate on the growth stocks in the traditional account.

401(k) Plans

A 401(k) account is an employer-sponsored plan, which means you can’t open one at your preferred brokerage like a traditional or Roth IRA. Only your employer can open one, and you often must opt-in to participate. The contribution limits are much higher for 401(k) accounts, but the investment selection is far narrower than that of IRAs.

Contributions

Contribution limits for 401(k) accounts vary depending on who contributes, the employee or the employer. The total 401(k) contribution limit in 2024 is $69,000, including employee and employer contributions. To max out your 401(k), you must consider both types of contributions.

In 2024, people under age 50 can save up to $23,000 for the employee portion, with an additional $7,500 available for those 50 and older. The difference between employee and employer contributions is vital since employers often provide a percentage match on contributions. 

For example, imagine your employer matches your contributions up to 5% of your salary. If you make $100,000, that’s an extra $5,000 that doesn’t count toward your $23,000 employee limit. If you’re 50 or older, you can contribute $30,500 on top of the $5,000 from your employer in 2024.

Withdrawals

A 401(k) account has withdrawal restrictions similar to an IRA's. Qualified distributions cannot be taken until age 59.5, although there are certain exceptions for medical expenses and disability. If you withdraw money from a 401(k) before age 59.5, you’ll face a 10% penalty in addition to any taxes on your contributions and investment growth.

RMDs also apply to 401(k) accounts. Once you reach age 73, you must begin taking RMDs unless you’re still employed and your plan allows you to defer them. Another possibility for tapping a 401(k) is through a loan if your employer allows it. A 401(k) loan often comes with better rates than consumer loans (and you’re technically borrowing from yourself), but you must repay the balance within five years.

Investing Options

Unlike an IRA, your investment selection is limited by your employer's choice. In most cases, this will be a combination of mutual funds, such as equity, bond, target-date, etc. Here are the types of assets available for 401(k) investments:

• Mutual funds
• Company stock
• Annuities

Some plans allow employees to invest in their own company stock, but you won’t be able to purchase equities, bonds, derivatives, real estate, or currencies. In most cases, you’ll simply be selecting from a group of mutual funds. 

Choosing The Right Plan For You

Retirement planning is a necessary process that often benefits from including an advisor. Tax-advantaged vehicles like IRAs and 401(k) accounts must be used properly to maximize their perks. For example, if you earn a high salary, you might not be able to fund a Roth IRA directly, but you can use the backdoor conversion from a traditional IRA to get tax-free investment growth.

Picking the right plan means considering several different factors. When discussing with your advisor, make sure to bring up the following:

• Your current financial situation (salary, other investments, spousal income/benefits)
• Goals and retirement timeline
• Personal risk tolerance
• Tax planning
• Employer offerings

Utilize Tax-Advantaged Accounts For Smoother Retirement Saving

The government encourages us to save for retirement through tax-deferred savings vehicles, so using them as part of our nest eggs makes sense. However, navigating the different benefits and rules can be confusing, so retirement planning should always be collaborative. Use resources like MarketBeat’s tools and research, and consult with a financial advisor specializing in creating individual plans. Making money mistakes is natural when we’re young, but the consequences of a retirement planning mistake can be devastating.

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