The Essentials
At a Glance
- Each account type changes when, and sometimes whether, growth is taxed.
- Deferring tax lets earnings compound on money that would otherwise have gone to tax.
- Withdrawals follow rules, and breaking them can bring taxes and penalties.
Why does the same investment behave differently depending on which account holds it? The answer is that certain accounts carry special tax treatment set by law, and that treatment can make a large difference over decades.
The three points where tax can apply
Money in an investment account can be taxed at three moments: when it goes in, while it grows, and when it comes out. An ordinary taxable brokerage account applies tax at all three. Contributions are made with money that has already been taxed, interest and dividends are taxed in the year received, and gains are taxed when an investment is sold.
Tax-advantaged accounts remove tax at one or more of those points. Which points are removed, and under what conditions, is what separates one account type from another. Every one of them comes with rules about who may contribute, how much, and when money may be withdrawn, and the IRS sets annual limits that change over time.
Pre-tax and after-tax contributions
A pre-tax contribution is deducted from your taxable income in the year you make it. If you earn $100,000 and contribute $10,000 pre-tax, you are taxed as though you earned $90,000. The tax on that $10,000 has not been avoided; it has been postponed until the money is withdrawn, at which point the withdrawal is taxed as ordinary income.
An after-tax contribution offers no deduction now. The money has already been taxed, and in a Roth-type account, qualified withdrawals of both contributions and growth are generally free of income tax. The choice between the two is largely a question of whether you expect your tax rate to be higher now or later, which no one knows for certain.
"Tax-deferred" describes an account where growth is not taxed year by year but is taxed on withdrawal. "Tax-free growth" describes an account where qualified withdrawals of growth are not taxed at all.
The main account types, briefly
Employer retirement plans, such as a 401(k), allow employees to contribute through payroll, often pre-tax and sometimes with a Roth option. Many employers add a matching contribution, which increases what goes into the account beyond the employee's own deposit.
Individual retirement accounts, or IRAs, are opened by the individual rather than an employer. A traditional IRA may allow a deductible contribution and grows tax-deferred; a Roth IRA is funded after tax and offers tax-free qualified withdrawals. Eligibility for deductions and for Roth contributions depends on income and on whether you are covered by a workplace plan.
Health savings accounts, or HSAs, are available to people enrolled in certain high-deductible health plans. They are unusual in that contributions are generally pre-tax, growth is untaxed, and withdrawals for qualified medical expenses are also untaxed. Unused balances carry forward, which is why some savers treat them as a long-term account rather than a spending account.
Education savings plans, such as 529 plans, are funded after tax, grow untaxed, and allow tax-free withdrawals for qualified education expenses. Some states offer a state tax benefit for contributions. Rules about which expenses qualify, and what happens to unused funds, have shifted over the years and vary by state.
Why deferral matters: a worked example
Suppose, for illustration only, two investors each put $10,000 into the same investment, which earns a hypothetical 6% a year for twenty years. Assume a hypothetical 25% tax rate throughout, chosen simply to make the arithmetic clear.
The first investor uses a taxable account and, for simplicity, pays 25% tax on each year's earnings as they arrive. That leaves a net growth rate of 4.5%, and after twenty years the account holds roughly $24,100.
The second investor uses a tax-deferred account. The full 6% compounds untouched, and after twenty years the account holds roughly $32,100. When the investor withdraws everything and pays 25% tax on the $22,100 of growth, roughly $26,600 remains.
The difference, about $2,500 in this simplified illustration, comes entirely from letting money that would have gone to annual taxes keep compounding. The gap widens with a longer horizon, a higher return, or a lower tax rate at withdrawal, and it narrows if the tax rate at withdrawal turns out to be higher. Real taxable accounts also enjoy some deferral of their own and may qualify for lower rates on long-term gains, so actual results depend on the details.
A tax-advantaged account does not change what an investment earns. It changes how much of the earning you keep, and when.
Withdrawals have rules
The tax benefits come with conditions. Retirement accounts generally impose a penalty on withdrawals made before an age set by law, with certain exceptions. Traditional accounts require minimum distributions to begin once the owner reaches a specified age. Roth accounts require that the account has been open for a minimum period before growth can be withdrawn tax-free. HSAs and education plans tax, and may penalize, withdrawals used for non-qualified purposes.
These rules change periodically and interact with your broader tax picture in ways that are easy to misjudge. A qualified tax professional can help you understand how they apply to your circumstances before a decision becomes irreversible.
Questions to Discuss With Your Advisor
- Given my current and expected future income, how should I think about pre-tax versus Roth contributions?
- Am I taking full advantage of any employer matching contribution available to me?
- Which of my goals, from retirement to health costs to education, could be served by a specific account type?
- How do the withdrawal rules on my accounts fit with the timing of my planned spending?
