Retirement account contributions: understanding the tax benefits of IRAs, 401(k)s, and more

Retirement accounts are among the most powerful tools in the tax code for building long-term wealth. Whether you're just starting your career or approaching retirement, understanding the various account types and their tax implications can save you thousands of dollars over your lifetime. This guide explains the major retirement account options, how they're taxed, and how to decide which accounts deserve your contributions. The tax benefits these accounts provide are significant, and using them effectively requires understanding both the rules and the strategic considerations involved.

The two fundamental tax approaches: traditional vs. Roth

Before diving into specific account types, it's essential to understand the two fundamental tax treatment approaches that apply across most retirement accounts: traditional (pre-tax) and Roth (after-tax).

Traditional accounts give you a tax deduction when you contribute. Your money grows tax-deferred—you pay no taxes on dividends, interest, or capital gains while the money remains in the account. However, you pay ordinary income tax on withdrawals in retirement. The benefit is that you defer taxes from your working years (when you may be in a higher bracket) to retirement (when you may be in a lower bracket).

Roth accounts work oppositely: you contribute money that's already been taxed (no deduction), but all growth and qualified withdrawals are completely tax-free. The benefit is that you pay taxes at today's known rate and never pay taxes on decades of growth.

Neither approach is universally better—the right choice depends on your current tax bracket, expected future tax bracket, time horizon, and personal preferences about tax certainty. Many financial planners recommend having both traditional and Roth assets for tax diversification in retirement.

401(k) plans: the workplace workhorse

The 401(k) is the most common employer-sponsored retirement plan, named after the section of the tax code that created it. These plans allow employees to contribute a portion of their salary before taxes (traditional 401(k)) or after taxes (Roth 401(k), if offered by the employer).

Contribution limits

For 2024, employees can contribute up to $23,000 to their 401(k) plans. If you're 50 or older, you can make an additional $7,500 catch-up contribution, for a total employee contribution of $30,500.

Importantly, these limits apply to your contributions only. Employer matching contributions don't count against your limit. The total combined limit (employee contributions plus employer contributions plus any after-tax contributions) is $69,000 for 2024 ($76,500 if 50 or older).

The employer match: free money

Many employers offer matching contributions—for example, matching 50% of your contributions up to 6% of your salary. This is essentially free money, and financial experts universally recommend contributing at least enough to capture the full employer match before considering other investment options.

A common match structure might work like this: if you earn $80,000 and your employer matches 50% of contributions up to 6% of salary, you'd need to contribute $4,800 (6% of $80,000) to get the maximum match of $2,400. That's an immediate 50% return on your contribution—far better than any other investment can reliably offer.

Traditional vs. Roth 401(k)

Many employers now offer both traditional and Roth 401(k) options. You can split contributions between them, as long as your total employee contribution doesn't exceed the annual limit. The choice between them follows the general traditional vs. Roth logic: traditional if you expect to be in a lower tax bracket in retirement, Roth if you expect to be in a similar or higher bracket.

Note that employer matching contributions are always made pre-tax to a traditional account, regardless of whether your own contributions go to a Roth 401(k).

Individual Retirement Accounts (IRAs)

IRAs are personal retirement accounts that you open and manage yourself, separate from any employer. They offer similar tax benefits to 401(k)s but with lower contribution limits and, for traditional IRAs, income-based restrictions on deductibility.

Contribution limits

For 2024, the contribution limit for IRAs is $7,000, with an additional $1,000 catch-up contribution if you're 50 or older. This limit is shared across all your IRAs—you can't contribute $7,000 to a traditional IRA and another $7,000 to a Roth IRA; your combined contributions can't exceed $7,000 (or $8,000 if 50+).

Traditional IRA deductibility

Anyone with earned income (wages, self-employment income, etc.) can contribute to a traditional IRA, but whether that contribution is tax-deductible depends on whether you're covered by a retirement plan at work and your income level.

If neither you nor your spouse is covered by a workplace retirement plan, your traditional IRA contributions are fully deductible regardless of income. If you are covered by a workplace plan, the deduction phases out at certain income levels. For 2024, single filers covered by a workplace plan see the deduction phase out between $77,000 and $87,000 of modified adjusted gross income (MAGI). For married couples filing jointly where the contributor is covered, the phase-out is $123,000 to $143,000.

Even if your contribution isn't deductible, you can still make non-deductible traditional IRA contributions. However, this is generally less advantageous than a Roth IRA (if eligible) because non-deductible traditional IRA contributions still result in taxable growth when withdrawn, whereas Roth growth is tax-free.

Roth IRA eligibility and benefits

Roth IRA contributions are never tax-deductible, but qualified withdrawals are completely tax-free—including all the growth. To contribute directly to a Roth IRA, your income must be below certain thresholds. For 2024, the ability to contribute phases out between $146,000 and $161,000 for single filers and $230,000 and $240,000 for married filing jointly.

Roth IRAs have unique advantages beyond tax-free growth. Unlike traditional IRAs and 401(k)s, Roth IRAs have no required minimum distributions (RMDs) during the owner's lifetime, making them excellent for estate planning. Additionally, you can withdraw your contributions (but not earnings) at any time without taxes or penalties, providing more flexibility than other retirement accounts.

The backdoor Roth IRA

If your income exceeds the Roth IRA limits, you may still be able to get money into a Roth through the "backdoor" strategy. This involves making a non-deductible contribution to a traditional IRA and then immediately converting it to a Roth IRA. The conversion is a taxable event, but since you just contributed the money (with no growth), the tax is minimal or zero.

This strategy is more complicated if you have existing pre-tax IRA balances due to the pro-rata rule, which requires you to treat all your traditional IRAs as one account for conversion purposes. Consult a tax professional before attempting a backdoor Roth to ensure it's executed correctly.

SEP IRAs for self-employed individuals

A Simplified Employee Pension (SEP) IRA is a retirement account for self-employed individuals and small business owners. SEP IRAs allow much higher contributions than traditional or Roth IRAs, making them attractive for those with substantial self-employment income.

For 2024, you can contribute up to 25% of net self-employment income (after the deduction for half of self-employment tax), with a maximum contribution of $69,000. The contribution is tax-deductible, reducing both income tax and self-employment tax.

SEP IRAs are simple to establish and maintain, with no annual IRS filing requirements. They're particularly useful for freelancers, consultants, and small business owners who want to maximize tax- deductible retirement savings. The main limitation is that all contributions are employer contributions (even if you're both the employer and employee), so there's no Roth option.

Solo 401(k) for self-employed individuals

A solo 401(k), also called an individual 401(k), is available to self-employed individuals with no employees (other than a spouse). It offers even higher contribution limits than a SEP IRA and includes a Roth option.

With a solo 401(k), you can contribute as both an employee and an employer. As the employee, you can contribute up to $23,000 (plus $7,500 catch-up if 50+). As the employer, you can contribute up to 25% of net self-employment income. The combined total can reach $69,000 (or $76,500 with catch-up contributions).

The employee contribution portion can be designated as Roth contributions if the plan allows, providing tax-free growth potential. This combination of high limits and Roth availability makes solo 401(k)s particularly attractive for high-earning self-employed individuals.

SIMPLE IRAs for small businesses

Savings Incentive Match Plan for Employees (SIMPLE) IRAs are designed for small businesses with 100 or fewer employees. They're less complex to administer than traditional 401(k) plans but offer lower contribution limits.

For 2024, employees can contribute up to $16,000 to a SIMPLE IRA, with a $3,500 catch-up contribution for those 50 and older. Employers must either match employee contributions up to 3% of compensation or make a 2% non-elective contribution for all eligible employees.

SIMPLE IRAs can be a good option for small businesses that want to offer retirement benefits without the administrative burden of a 401(k) plan. However, the lower contribution limits may be a drawback for owners or high-earning employees who want to maximize retirement savings.

Health Savings Accounts: the stealth retirement account

While technically designed for healthcare expenses, Health Savings Accounts (HSAs) offer unique tax advantages that make them powerful retirement planning tools. HSAs provide a triple tax benefit: contributions are tax-deductible, growth is tax-free, and withdrawals for qualified medical expenses are tax-free.

To contribute to an HSA, you must be enrolled in a high-deductible health plan (HDHP). For 2024, contribution limits are $4,150 for individual coverage and $8,300 for family coverage, plus a $1,000 catch-up contribution for those 55 and older.

The retirement planning angle: after age 65, you can withdraw HSA funds for any purpose—not just medical expenses—and pay only ordinary income tax (similar to traditional IRA withdrawals). Before 65, non-medical withdrawals face a 20% penalty plus income tax. But if you can afford to pay medical expenses out of pocket now and let your HSA grow, you'll have decades of tax-free growth for either future medical expenses or general retirement spending.

Many experts consider maxing out an HSA to be a higher priority than contributing beyond the employer match to a 401(k), given the unique triple tax advantage.

Putting it together: a contribution priority framework

With so many account options, deciding where to put your retirement savings can feel overwhelming. Here's a general framework that many financial planners recommend, though your specific situation may call for a different approach:

• First priority: Contribute enough to your 401(k) to get the full employer match. This is guaranteed return on your money.
• Second priority: Max out your HSA if you're eligible. The triple tax advantage is unmatched.
• Third priority: Contribute to a Roth IRA (if income-eligible) or backdoor Roth IRA. This builds tax-free retirement assets with no RMDs.
• Fourth priority: Max out your 401(k) or equivalent workplace plan. The high contribution limits allow significant tax-deferred savings.
• Fifth priority: Consider taxable brokerage accounts, additional after-tax 401(k) contributions (if available), or other investment vehicles.

Self-employed individuals would substitute SEP IRAs or solo 401(k)s for the employer 401(k) discussion, and the specific priority may shift based on income levels and tax situation.

Withdrawal rules and penalties

Retirement accounts come with restrictions designed to encourage leaving the money invested until retirement. Generally, withdrawals before age 59½ from traditional accounts face a 10% early withdrawal penalty on top of ordinary income tax. Roth accounts have more flexibility—contributions (but not earnings) can be withdrawn anytime without penalty.

There are exceptions to the early withdrawal penalty, including substantially equal periodic payments (SEPP/72(t) distributions), certain medical expenses, first-time home purchases (limited amount from IRAs), and others. However, these exceptions have complex rules, and it's generally best to leave retirement funds alone until retirement if possible.

Traditional accounts (except Roth IRAs) require minimum distributions starting at age 73, ensuring that tax-deferred money eventually gets taxed. Roth IRAs have no RMDs during the owner's lifetime, though inherited Roth IRAs do have distribution requirements for beneficiaries.

The power of starting early

Perhaps the most important retirement planning concept is the power of compound growth over time. Starting early—even with small contributions—can result in dramatically more wealth than starting later with larger contributions.

Consider two scenarios: Person A contributes $500 per month from age 25 to 35 (10 years, $60,000 total contributed) and then stops. Person B contributes $500 per month from age 35 to 65 (30 years, $180,000 total contributed). Assuming 7% annual returns, Person A ends up with more money at age 65, despite contributing only one-third as much. That's the power of compound growth—the early contributions have more time to grow.

The tax advantages of retirement accounts amplify this effect. Every dollar saved in taxes (from deductions or tax-free growth) is another dollar that compounds over time.