Putting money into retirement accounts can be a smart way to create a nest egg for your future self. But a tax-efficient retirement plan goes beyond focusing on how much to save and what investments to buy. Being strategic about where you put your money can help minimize your tax bill during retirement.
Some factors will be out of your control, such as whether tax rates or Social Security payments change in the future. Even so, incorporating tax planning can be an important part of managing your finances and preparing for retirement.
Why tax-focused diversification can be important
Diversifying your investments is a fundamental part of managing risk, and you’ll want to occasionally rebalance your portfolio to align with your current situation and goals. Similarly, diversification within the types of accounts you’ll use for retirement can also be important.
By putting money into various types of accounts, you can give yourself the option to withdraw money from different sources depending on your tax situation during each year of retirement.
For example, if you don’t need a lot of money in one year, you might draw from your taxable accounts since you’ll be in a low tax bracket. If you need more income for traveling or home upgrades the next year, you could prioritize tax-free withdrawals to avoid pushing yourself into a higher tax bracket.
The three main types of tax-advantaged accounts
There are three types of tax-advantaged accounts that you may want to use for retirement. Each has its own rules for eligibility, contributions limits and withdrawals. But here, we’ll focus on the tax implications for the accounts.
| Type of Account | Tax-Deductible Contributions | Tax-Free Growth | Tax-Free Withdrawals |
| Traditional retirement accounts | Yes | Yes | No |
| Roth accounts | No | Yes | Yes |
| Health savings accounts | Yes | Yes | Yes (for qualified medical expenses) |
Traditional tax-deferred accounts
With a traditional tax-deferred account, you could receive a tax deduction for the money you contribute each year. These accounts may include:
- 401(k)
- 403(b)
- 457(b)
- IRA
- Some pensions and annuities
Your investments can grow tax-free, meaning you don’t have to pay income taxes on your earnings each year, which might increase your returns in the long run. However, the money you withdraw from these accounts will be taxable income during retirement.
Traditional individual retirement accounts (IRAs) and employer-sponsored plans, such as 401(k)s, may have required minimum distributions (RMDs). These required withdrawals generally start when you turn 73, but you may be able to delay RMDs for employer-sponsored plans until you retire.
Missing RMDs can lead to a 25% penalty, based on how much you should have withdrawn, so you’ll want to consider how the RMDs will affect your income and withdrawal plan during retirement.
After-tax Roth accounts
You don’t get a deduction for contributing to Roth retirement accounts, which could include:
- Roth 401(k)
- Roth 403(b)
- Roth 457(b)
- Roth IRA
Your investments can grow tax-free within the account, and you may be able to make tax-free withdrawals once you turn 59 ½ years old. However, it has to have been at least five years since you first contributed to a Roth account. You can also withdraw your contributions—but not earnings—at any time without paying any penalties or taxes.
Starting in 2024, Roth IRAs and employer-sponsored plans don’t have RMDs.
Tax-free HSA accounts
You usually will have to pay taxes on your income now or later—there’s no getting around it. However, a health savings account (HSA) offers a triple-tax benefit. You can deduct contributions, your investments grow tax-free and you might be able to make tax-free withdrawals later.
To avoid taxes and penalties, you’ll need to use the money from your HSA for qualified medical expenses for yourself, a spouse or a dependent.
Some people use an HSA as a type of retirement account because there’s no time limit on when you have to withdraw money from the HSA. For example, if you’re 35 years old, have an HSA and have $5,000 in qualified medical expenses for the year, you could choose to withdraw that money now. Or, you could keep it invested and withdraw $5,000 for the expenses at any point in the future.
Other sources of retirement income
In addition to the money from tax-advantaged accounts, you may be able to diversify your retirement income with other types of accounts and benefits:
- Savings: You might have money in checking, savings, money market account and certificate of deposit (CD) accounts for short- to medium-term expenses. Interest earnings could be taxable as regular income.
- Social Security: Your Social Security benefits can depend on how much you contributed to Social Security while working and when you start taking benefits. Up to 85% of the benefits may be taxable depending on your tax filing status and household income for the year. You can create a my Social Security account to check your contributions and estimated benefits.
- Municipal bonds: Municipal bonds can offer a relatively safe and fixed income. The earnings are also often tax-free on the federal level, and municipal bonds from your state also might be exempt from state income taxes.
- Brokerage accounts: Earnings from investments you have in regular brokerage accounts may be taxed as capital gains or ordinary income, depending on whether you held the asset for at least a year.
- Other income streams: You might also have other sources of taxable income, such as rental properties, a business, annuities or royalties.
Every source of taxable income could affect your tax bill and change which types of tax-advantaged withdrawals you want to prioritize. Keep this in mind as you strategize your retirement contributions.
Create a plan with a professional
Having diverse income streams can help minimize your taxes during retirement. Understanding how the different types of retirement accounts work can be an important part of creating a tax-efficient retirement plan.
However, you may still want to work with a professional who specializes in financial planning and taxes to create a personalized plan based on your retirement goals.
Whether you’re planning for your retirement or your family’s future, Byline Bank’s Wealth Management team is ready to provide customized solutions for your financial needs. Get in touch.
