Saving for retirement is important. At the same time, nobody wants to pay more than their fair share in taxes. Fortunately, there are several tax-advantaged retirement accounts available. Refresh your knowledge of accounts designed to incentivize saving for retirement while potentially reducing tax consequences.
Types of Tax-Advantaged Retirement Accounts
Employer-Sponsored 401(k)s/403(b)s
If an employer offers a 401(k) plan, it can be an easy way to set aside money for retirement. Nonprofit employers, schools and governments may offer a similar account called a 403(b). What’s more, many employers match all or part of employee contributions, giving an extra boost for retirement.
Employee contributions to a 401(k) or a 403(b) are made pretax, so they can lower taxable income now. If permitted by the plan, participants age 50 or over at the end of the calendar year also may be able to make catch-up contributions up to $7,500 in 2023.
When money is withdrawn in retirement, it’s taxed as ordinary income. However, penalties may also apply if money is withdrawn before reaching age 59½. In some cases, participants in a plan may be able to borrow from a 401(k) or 403(b), but they’d need to pay back that money with interest usually within five years. Other rules and restrictions may apply.
Traditional IRAs and Roth IRAs
Savers may be able to contribute to an individual retirement account (IRA) even if they have a retirement savings plan through work. You’ll want to check the IRS’ eligibility requirements and contribution limits that are set each year.
For 2023, savers may be able to contribute up to a total of $6,500 in a Roth and/or traditional IRA if the saver or spouse have earned income. Those over age 50 may also be able to contribute an extra $1,000 per year.
However, these accounts are taxed differently after age 59½:
With Roth IRAs, contributions were taxed when that money was earned. No additional taxes are imposed when the funds are withdrawn in retirement, including the gains earned on the contributions—provided the distribution is a qualified distribution.
Unlike traditional IRAs, Roth IRAs generally do not include required minimum distributions by age 72.Contributions to traditional IRAs are not taxed when they flow into the account. Thus, they may reduce current taxable income if the saver does not exceed the IRS’ defined income limits.
Withdrawals are subject to taxes, including the gains on the contributions. Generally, early withdrawals are subject to your gross income tax rate plus a 10% tax penalty (check with the IRS for exceptions).
SEP IRAs
A simplified employee pension (SEP) is a retirement savings option available to any person running a business, including solopreneurs. The employer sets up a SEP IRA for each eligible employee, and only the employer contributes to it following IRS rules.
SEP contributions are tax deductible for the employer and are excluded from employees’ gross income. (Contributions are not subject to federal income tax withholding, Social Security, Medicare and federal unemployment taxes.)
The employee is always 100% vested in (or has ownership of) all SEP IRA money—but withdrawals are taxable income and may be subject to a 10% additional tax if taken before age 59½.
SIMPLE IRAs and SIMPLE 401(k)s
SIMPLE IRAs and SIMPLE 401(k)s give employers with 100 or fewer employees a way to contribute toward their employees’ and their own retirement savings. For both types of plans, employees can choose to contribute from their salaries. However, the employer must contribute to each employee’s plan even if the employee doesn’t.
For 2023, employees can contribute up to $15,500 from their salaries to a SIMPLE IRA or a SIMPLE 401(k). In both cases, these contributions are made with pretax money, so contributions and earnings are taxed when they’re withdrawn. Beginning at age 50, you also may be able to make a catch-up contribution, up to $3,500 in 2023.
Health Savings Accounts (HSAs)
People are living longer, and health care costs can be steep. HSAs can cover qualified out-of-pocket medical costs in retirement. These can include certain insurance premiums, deductibles, prescriptions and copays. Individuals must be covered under a high-deductible health plan in order to make contributions to an HSA. People who are on Medicare cannot contribute to an HSA, but they can use previous HSA savings to pay for expenses Medicare doesn’t cover.
Contributions to an HSA are tax deductible, and the earnings grow tax deferred. Withdrawals to pay for qualified medical expenses are not taxed—a key benefit of this tax-advantaged account. Withdrawals that are not used for qualified medical expenses will be taxed as ordinary income and subject to an additional penalty of 20% (the penalty does not apply once the HSA owner reaches age 65, but nonqualified withdrawals are still subject to ordinary income taxes). When the owner of the HSA dies, a surviving spouse may continue receiving this preferred tax treatment with a spousal rollover, provided the surviving spouse was the designated beneficiary on the HSA.
Got Taxable Accounts? Consider Tax-Efficient Investments
Understanding the Tax-Efficiency of ETFs
In some cases, you still might choose to invest in a taxable investment account. You won’t have the tax benefits of a 401(k) or other tax-advantaged retirement savings account, but you won’t face penalties if you need to withdraw money before retirement age.
Exchange-traded funds (ETFs) are one option to consider in a taxable investment account because they have distinguishing features that may make them more tax efficient than mutual funds.
Take Advantage of the Tax Savings
It’s possible that more than one account could fit your situation. Using this “cheat sheet” of tax-advantaged retirement accounts can help you find opportunities to save for retirement in a tax-savvy way.
IRS Circular 230 Disclosure: American Century Companies, Inc. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with American Century Companies, Inc. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties.
This information is for educational purposes only and is not intended as tax advice. Please consult your tax advisor for more detailed information or for advice regarding your individual situation.
Please consult your tax advisor for more detailed information regarding the Roth IRA or for advice regarding your individual situation.
Taxes are deferred until withdrawal if the requirements are met. A 10% penalty may be imposed for withdrawal prior to reaching age 59½.
IRA investment earnings are not taxed. Depending on the type of IRA and certain other factors, these earnings, as well as the original contributions, may be taxed at your ordinary income tax rate upon withdrawal. A 10% penalty may be imposed for early withdrawal before age 59½.
Regarding SIMPLE IRAs:
Taxes are deferred until withdrawal if the requirements are met. A 10% penalty may be imposed for withdrawal prior to reaching age 59½.
If withdrawals are made within the first two years of participation in the SIMPLE IRA, the penalty increases to 25%.
You could lose money by investing in a mutual fund, even if through your employer's plan or an IRA. An investment in a mutual fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.
This information is for educational purposes only and is not intended as a personalized recommendation or fiduciary advice. There are different options available for your retirement plan investments. You should consider all options before making a decision. Our representatives can help you evaluate all of your distribution options.