Using Tax-Advantaged Accounts

This article is US-specific.

If you work a well compensated W-2 job, your taxes are high. You lack many of the opportunities to minimize your taxes that investors, self-employed people, and startup founders have.

But you still have some, and this article will tell you how to max them out.


  • Tax-deductible contributions
  • Tax-deferred growth
  • Tax-free distributions

401(k) plans allow you to set aside a portion of your income to grow in a tax-deferred way. Any income you contribute to the 401(k) is not taxed as income in the current year. Moreover, the investments can grow without paying taxes while they remain in the 401(k) account.

But when you withdraw money from the 401(k) in retirement, then all the money in the 401(k) is taxed as ordinary income.

But your tax rate should be low in retirement, so this tax-advantaged vehicle should let you come out way ahead.

The downside is that this money is locked up until 59½ years of age unless you pay a 10% early withdrawal penalty. But that should be okay.

Employer 401(k) Matching

Moreover, most larger employers will match a portion of your contribution with their own money. This is literally free money.

If you do not value the tax-advantaged aspect of the 401(k) at all, and don’t want your money locked up until you are 59½, you can still contribute to your plan, get the employer match, and immediately withdraw the whole balance, paying the 10% penalty along the way.

Even after a 10% penalty, with an employer match you should still come out ahead.

My advice: Max out the employer match no matter what, unless you hate free money.

Roth 401(k) and Mega Backdoor

  • Tax-deductible contributions
  • Tax-deferred growth
  • Tax-free distributions

This is the Roth equivalent of the 401(k). Instead of getting a tax deduction now, you pay ordinary income taxes immediately, and get tax-free distributions instead.

Your annual elective deferral limit is shared between 401(k) and Roth 401(k). You can choose to contribute to a Roth 401(k) for your elective deferral limit instead of a Traditional 401(k).

I don’t recommend it, and here’s why:

  1. Most likely, your tax rate is higher now than in retirement. Roth vehicles are a good way to prepay taxes now in exchange for no taxes upon distribution time. But generally you can somewhat control when the distribution time is, and do it during a low income / low tax-rate year.

  2. When you contribute money to Traditional 401(k), you can later choose to roll that over into an Roth IRA, which is in-effect electing to pay income taxes that year in exchange for a tax-free distribution. In that sense, traditional 401(k)s are deferred income you can choose to realize at an advantageous time. It’s dry powder. Contributing to a Roth 401(k) directly negates that advantage.

But many companies now allow for Mega Backdoor, which is a way to dump an extra huge amount of money each year into a Roth 401(k) or Roth IRA above the elective deferral limit. The details are complicated, and it’s best to refer you to the details here: Mega Backdoor Roths.

IRA and Spousal IRA (Individiual Retirement Account)

You can also contribute to a IRA each year from your taxable income. In 2023, the limit is $6,500 for those under age 50, and $7,500 for those over age 50.

Traditional IRA is good if you have a high marginal tax rate and you are below the AGI limit. Here are their characteristics:

  • Tax-deductible contributions
  • Tax-deferred growth
  • Tax-free distributions

If you are below the AGI limit and you have a low marginal tax rate, you should make a Roth IRA contribution instead of a Traditional IRA contribution. Here’s how Roth IRAs behave:

  • Tax-deductible contributions
  • Tax-deferred growth
  • Tax-free distributions

If you are above the AGI limit, you can only make a Roth IRA contribution by making a Backdoor Roth IRA contribution.

This consists of the following steps:

  1. If you have any Traditional IRA balance that has gains, first roll that over to a 401(k). You need to do this, as the pro-rata rule will force you to pay taxes on gains in your Traditional IRAs when you do a rollover. By first rolling over any Traditional IRA balance with gains, you avoid this, because the pro-rata rule doesn’t apply to 401(k)s.

  2. Make a contribution to your Traditional IRA account. If you are above the AGI limit, this will be non-deducitble, but that’s completely fine.

  3. Roll over your entire Traditional IRA balance into your Roth IRA account.

  4. Done, now you’ve effectively made a contribution to your Roth IRA account even if you are above the AGI limit.

If you work and your spouse is stay-at-home, you are still able to contribute to an IRA on their behalf, effectively doubling your marital limit. See here for more details.

A spousal IRA can either be a Traditional IRA or a Roth IRA. You can do Backdoor Roth for a Spousal IRA too.

HSAs (Health Savings Accounts)

If you have a high-deductible health insurance plan, you are also eligible to make a tax-deductible contribution to an HSA, let it grow tax-free, AND withdraw the appreciated assets tax-free to pay for eligible medical expenses.

They are triply advantaged:

  • Tax-deductible contributions
  • Tax-deferred growth
  • Tax-free distributions (for eligible medical expenses only)

Moreover, there’s currently NO time limit for when you need to take a tax-free distribution after paying for a medical expense. So you can use the “shoebox method” of paying for your medical expenses out of pocket, keeping the receipt in a shoebox, and then taking money out of your HSA decades later after a lot of tax-free appreciation.

In this way, HSAs can be treated like just another tax-advantaged retirement savings account.

The shoebox method works, because you will likely have medical expenses after retirement.

If you do NOT have enough medical expenses there are STILL a number of other escape hatches:

  1. Your spouse can inherit the HSA balance tax-free and use it on their own medical expenses.

  2. After age 65, you can use the HSA balance for any purpose if you pay income taxes on the distributions. In that way, it is no worse than a Traditional IRA.

  3. And anyone else inherits it, they pay income tax on the balance.

One warning: If you withdraw the HSA funds before the age of 65 for non-medical expenses, they will be subject to a 20% penalty in addition to income tax on the distribution. Don’t do this.

One more warning: If you live in California or New Jersey, HSA contributions are not tax-deductible for State Income Tax, and HSAs are taxed on dividends and capital gains too. Those two states are NOT compliant with federal HSA rules. But HSAs are still worth it for residents of that state.

529 Plans (College Savings)

  • State-tax deduction or credit (only in some states)
  • Tax-deferred growth
  • Tax-free distributions (only for qualified educational expenses)

529 plans are kind of weird. They have state-tax deduction or credits in some states.

But after that they behave a lot like a Roth IRA only for qualified educational expenses for a designated beneficiary (usually your child).

But they are actually pretty flexible:

  • The beneficiary can be changed to a family member of the existing beneficiary.
  • The new beneficiary can be yourself.

I probably don’t recommend saving 100% of the anticpated educational expenses for a child to go to a private 4 year college in a 529 account though, unless you have unique circumstances.

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