In a taxable brokerage account, every time you receive a distribution or realize a gain or loss, there is a taxable event — an event that affects your tax reporting and usually your tax liability. We'll cover various kinds of tax-advantaged accounts, but they all share one feature: your trades in the account are sheltered from tax. On top of other benefits, capital gains and distributions are never taxed while the money is in the account, and you can adjust investments as often as you want with no concern for tax implications. As an example in a later section illustrates, this is a massive advantage over a taxable account.
In this context, "earnings" or "investment earnings" refer to the growth in value of investments in these accounts. Withdrawals from the account are called "distributions", and "qualified distributions" are withdrawals that are penalty-free because they comply with the purposes of the account.
Major changes were made to some rules for tax-advantaged accounts by the SECURE Act of 2019 and the SECURE 2.0 Act of 2022. Any source you find that was written or last updated before December 2022 may contain outdated information.
Click to move to each section:
- Retirement accounts
- Health savings account (HSA)
- Contribution limits
- Rollovers and transfers
- Five-year rules for your Roth IRA
- 529 account
- HSA rebels
- Required minimum distributions (RMDs)
- Charity
- Later sections
- Summary
- Footnote: Hardship withdrawals and 401(k) "loans"
Most tax-advantaged retirement accounts are either an IRA (individual retirement account), which you control completely, or an employer-sponsored 401(k) account. They incentivize retirement planning by offering the opportunity to save a great deal on taxes if you set aside the money until old age. There are two types of retirement account plans that reduce taxes in different ways, and an individual can use one or both each year.
With a traditional plan, your contributions are tax-deductible in that year and investments in the account are protected from tax as they grow. The drawback is that while traditional accounts reduce taxes in the year of contribution, withdrawals are subject to income tax. With a Roth plan, contributions don't reduce your income tax, but earnings in the account are tax-protected and qualified distributions (i.e., withdrawals) are tax-free. So when you contribute money to a Roth account, you can invest it for as long as you want and withdraw it without ever owing tax again. Why use a traditional plan? You can reduce income tax when you're working and paying high tax rates, and instead wait to pay that income tax in old age, when most people have little or no income and pay low tax rates.
Roth accounts are tax-exempt (pay now, as you normally would) and traditional accounts are tax-deferred (pay later). The distinctions introduced so far provide four subdivisions: traditional IRA, Roth IRA, traditional 401(k), Roth 401(k).
Distributions are meant to be delayed until age 59½, so early withdrawals are hit with a 10% tax penalty on top of triggering any income tax owed. Once you turn 59½, you can withdraw any amount penalty-free. Uniquely, you can withdraw all of your cumulative contributions to a Roth IRA tax- and penalty-free regardless of your age. So if you've contributed $26K to a Roth IRA over several years, you can freely withdraw up to $26K at any time. If you expect your income to rise over time, it makes sense to contribute to Roth accounts earlier in life and traditional accounts later in life. I explore when to contribute to Roth and traditional accounts in the section on taxes.
The only one who contributes to your IRA is you, but a 401(k) account can receive contributions from your employer as well. Most employers contribute to your employer-sponsored account according to a matching policy they dictate. Because matching policies vary greatly, you should inquire about a potential employer's policy when considering a job. It's part of your compensation. If there's a 50% matching policy up to 6% of your income, your employer would contribute 3% of your income if you contribute 6%. So you would earn a risk-free 50% return simply by contributing up to 6% of your gross income. Unless you hate money, you should max out employer matching every year in your 401(k). In this case, that would mean contributing at least 6% of your pre-tax income.
There are two exceptions. The first is if you're drowning in debt, barely able to make interest payments. If you're anywhere close to this situation, you shouldn't be contributing to retirement accounts. Someone with manageable debt should contribute if they have a high matching rate. An account with 50% matching is one of the few places to invest your money more effectively than paying off high-interest debt. But if you have debt due to issues with responsible spending, addressing that should be the priority. The other exception is if you plan to leave your company soon, and your matching contributions to a 401(k) will not fully vest. What does this mean? To incentivize retention, your employer may require a certain period of working years until your matching contributions belong to you completely. That is, until you are 100% vested, some or all of your matching contributions may be revoked if you leave. If you left while you were 40% vested, the employer would be able to claw back 60% of their contributions. They also claw back the earnings on those contributions, but this is fair because it applies even if earnings have been negative, in which case they claw back less money than they contributed. Vesting may increase by 20 percentage points each year, for example, but the schedule is up to the employer except for the legal requirement that it must reach 100% after six years. Once you are 100% vested after six years at most, all prior and future matching contributions are assured regardless of when you leave the company.
Once you've maxed out employer matching in a given year, you can continue your own contributions up to a legal limit. Not all employer contributions are matching contributions. Some employers make fixed contributions regardless of employee contributions. The 401(k) is the most common work retirement plan, so I'll often say "401(k)" as shorthand for all work retirement plans, but many people have others. The 403(b) account is a close relative, and one major difference is that employer contributions tend to vest more quickly (sometimes immediately). 403(b) plans are for nonprofits like public schools, universities, and hospitals. Work retirement accounts use an automatic investment plan, in which an employee decides on an amount or percentage to be deducted from each paycheck. This deduction is automatically contributed to the account and invested in the employee's chosen allocation. This tends to promote good investing behavior, because it doesn't let you hesitate to invest and stay out of the market, and it requires no attention unless you decide to change your allocation.
If the fees in your retirement plan are too high — which is a common problem — then it is quite possible to lobby for changes to the plan. You might be able to do this yourself at a very small business, or in collaboration with others at a large institution.
The IRS offers a major tax credit to those with low income who contribute to retirement accounts. Read about the saver's credit here.
TERMINOLOGY WARNING: Many people simply say "401(k)" with the implication of a traditional plan. Most 401(k) accounts are traditional, which means they are tax-deferred accounts. But many employers also offer a Roth 401(k), so it can be important to specify whether you're referring to a traditional 401(k) or a Roth 401(k). One more gripe: please don't capitalize every letter of "Roth". It's not an acronym, it's named after a US senator.
Properly used, an HSA has the most tax advantages of any account. Contributions are tax-deductible up to a limit, investments grow tax-free, and withdrawals for qualifying medical expenses are tax-free! The account can pay for your own medical expenses as well as those of your spouse, dependents, and certain non-dependent children. You can pay for medical expenses directly from the account, or you can wait and reimburse yourself later. The delay can be two days or 20 years, as long as you can document the payments and your HSA was open when the expenses were incurred. Documentation is not typically needed for HSA reimbursement — you can just reimburse yourself whenever you want. So it may never be used, but the IRS can request it if your tax returns are audited.
Unlike contributions to your IRA or 401(k), contributions to your HSA even escape FICA taxes — the federal payroll taxes that fund Social Security and Medicare — as long as you contribute through your employer’s payroll deduction. For most people, FICA taxes amount to 7.65% of every dollar of earned income. Your employer may offer matching in your HSA because this enables them to pay you while escaping their share of FICA taxes too.[1] HSAs do have a drawback: if you desperately need the money and withdraw it for non-medical reasons before age 65, you’ll pay a penalty of 20% — twice as high as in retirement accounts — in addition to income taxes. From a retirement perspective, you can use your HSA purely as an investment vehicle. After age 65, you can use it for medical expenses as you would have before, but the 20% penalty if you withdraw for other reasons will be gone. The withdrawals for non-medical reasons will be subject to income tax, but so would withdrawals from a traditional IRA or 401(k). Even in this situation, the HSA is superior because the contributions avoid FICA taxes on the front end, but contributions to an IRA or 401(k) do not.[2] An HSA is a stealth retirement account that beats retirement accounts at their own job.
You shouldn’t feel the need to choose between a dichotomy of investing or not investing in your HSA. If it suits you, you can spend some of your HSA funds on medical expenses throughout your life while investing a portion for old age. If you commit to an investment approach, you should max out HSA contributions every year and refrain from spending any of your HSA funds before 65, so that they appreciate maximally. You would pay for medical expenses before 65 from your checking account, not your HSA. This is a little counterintuitive, but it would allow your untaxed HSA contributions to spiral upward with tax-free capital gains, and much of the money would be withdrawn tax-free as well. As you age during retirement, you will probably spend far more on medical expenses than when you were younger, and maximizing your HSA would mean you’re able to fund those large expenses with invested money that has never been taxed. A small added bonus is that you benefit from credit card rewards by not paying with your HSA debit card; you can do this even if you don't invest in your HSA, and immediately withdraw the amount from your HSA after paying with your credit card.
HSAs can pay for a variety of health care expenses that may be surprising — not just co-pays, co-insurance, and deductibles. Eligible expenses include eyeglasses and contact lenses, braces, certain OTC medications like aspirin and ibuprofen, childbirth classes, therapy and psychiatric care, guide dog expenses, changes you make to your home for medical reasons, sunscreen, tampons and pads, alcoholism treatment, hearing aids, and out-of-pocket transportation expenses needed to travel to medical care. Certain items are conditionally eligible, such as wigs if your disease or treatment has caused hair loss. A letter of medical necessity from your doctor can greatly broaden the universe of eligible items. You can reference IRS Publication 502 as well as resources like HSA store (a private company) to check whether an item is eligible.
Before 65 you cannot pay for insurance premiums with your HSA unless you're receiving unemployment benefits or using COBRA, the federal program that allows you to keep your health insurance with a group plan after leaving a job by paying the full cost yourself. Once you turn 65, or enroll in Social Security or Medicare, you can no longer contribute to your HSA. But you can pay for some Medicare premiums with your HSA, as well as long-term care insurance premiums. If the investment approach were initiated early in life and maximized, you would contribute several hundred thousand dollars and have millions of dollars in the account by age 65. It is best used along with retirement accounts, which allow further tax-advantaged contributions each year and provide a source of last-resort funds that can be withdrawn with a lower 10% penalty. However, if your need for cash becomes dire and you’ve saved documentation of your medical expenses, you can withdraw HSA funds by reimbursing yourself for past medical expenses, then use that money for whatever else. This is worth underlining as one of the best features of your HSA: with ongoing medical expenses that build over time and have not been reimbursed, you have the freedom to withdraw and reimburse yourself for those expenses at any time, penalty- and tax-free. Meanwhile, that money stays in your HSA and enjoys tax-free investment. You could also use reimbursement as a means of tax-free withdrawal for normal expenses after 65, if your HSA funds exceed health needs.
Not every American can contribute to an HSA every year. You're eligible to contribute only if you have a high-deductible health plan (HDHP). If you contribute to your HSA while you have an HDHP, then switch to a non-HDHP, you can still use your HSA to spend and invest. You can resume contributions if you switch back to an HDHP. In order for a plan to count as an HDHP and thus be HSA-eligible, it must have a deductible of at least $1,600/$3,200 (single/family), and an out-of-pocket maximum of no more than $8,050/$16,100. These figures are for 2024 and are adjusted for inflation each year. Some plans with high deductibles are not HSA-eligible because their out-of-pocket maximums are too high. So despite its name, an HDHP is not simply a plan with a high deductible. If you decide to contribute to an HSA independently because your employer doesn't offer deposits through payroll deduction, be very careful to ensure that your plan is an HDHP. In addition to the two plan-specific requirements, you must have no other health coverage and must not be claimed as a dependent on someone else's tax return. Some employers don't offer contributions to an HSA through payroll deduction. Not contributing through payroll deduction means you won't benefit from the reduction in payroll taxes, but even without this, HSA contributions are often still worthwhile. Self-employed people may also find themselves in this situation.
It's beyond the scope of this guide to discuss the benefits and drawbacks of different plans for different people. The plans offered by an employer can sometimes make one option the clearly best choice. I'll simply say that people with a wide variety of medical expenses can find an HDHP to be suitable. HDHPs have lower premiums but higher deductibles. The unique tax benefits of an HSA, even if not used for investing, make HDHPs a good fit for more people than they would be otherwise. A typical person with a single plan saves over $1,200 in tax simply by maxing out their HSA, and that doesn't include all the future tax protection if they invest the money. Many people with a family plan can save over $2,500 per year in tax. On top of that, some employers contribute to their employees' HSAs, which is a benefit you forgo if you choose a non-HDHP. A large portion of private employees now use HDHPs. Unfortunately, not all employers offer one. You should always take health insurance options into account when considering job offers, because they have real financial consequences. And if you're a taxpayer in California or New Jersey, it's important to be aware of the tax treatment of HSAs in those states.
See the summary for a concise recap of the benefits of an HSA.
Contribution limits for 401(k) accounts are far higher than those for IRAs, which is a major benefit for people with high income. In 2024, IRA contributions are limited to $7,000 (or $8,000 for those who are at least 50), whereas the 401(k) limit is $23,000 (or $30,500 for those who are at least 50). The 401(k) limit is only for employee contributions; the limit for the sum of employee and employer contributions is a whopping $69,000 (or $76,500 for those who are at least 50). HSA limits are $4,150 for single plans and $8,300 for family plans, with an additional $1,000 for those who are at least 55. If your employer contributes to your HSA, the total allowed contribution is the same. The increased contribution limits for people over an age threshold enable "catch-up contributions". Note that the age thresholds are different for retirement accounts (50) and an HSA (55). The date on which you were born doesn't matter: anyone born in 1974 can start making catch-up contributions to their retirement accounts in 2024, because they turn 50 in that year. Beginning in 2026, high earners will be required to make catch-up contributions in a Roth account, rather than having the choice between traditional and Roth catch-up contributions.
Contributions to your 401(k), IRA, or HSA do not affect contribution limits in the other two types of accounts. You can contribute to Roth and traditional IRAs in the same year if you wish, but the joint contribution limit is no larger than if you contribute to only one (and the same for work retirement accounts). IRA contributions are also limited by gross earned income. If someone earned a pre-tax total of $4K from their job in a given year, they could contribute no more than $4K to an IRA (regardless of whether they realized capital gains or received cash dividends, neither of which counts as earned income). 401(k) contributions are inherently limited by earned income, because they're made through payroll deduction.
If you file taxes jointly with your spouse, you can both contribute to an IRA even if only one of you earns income, as long as the total IRA contributions don't exceed your joint earned income in that year.
For most people, the normal contribution limits for a work retirement plan are not a restriction. $23,000 is already more than they can save for retirement in a year. But for those with high income or wealth who want to contribute even more money to a Roth account, you can learn about mega backdoor Roth contributions.
If you don't have a high-deductible health plan (HDHP) for the entire year, you may not be eligible to contribute the maximum to an HSA. Let's say you change jobs in June and change your health insurance on July 1 from an HDHP (at your old job) to a non-HDHP (at your new job). HSA eligibility is determined on the first of each month, so you would be eligible for HSA contributions in January through June, the first six months of the year. This would reduce your maximum to 6/12 of whatever maximum would otherwise apply to you. You can still contribute to your HSA at any time — not just in January through June — but your maximum for that year would be cut in half.
This simple pro rata calculation is often how you determine whether your maximum contribution is reduced. But there is a last month rule: if you're covered by an HDHP on December 1, you're eligible to contribute the maximum regardless of when that coverage began. So if you switched from a non-HDHP to an HDHP on October 1, you would be eligible to contribute the full maximum, not just the pro rata 3/12 of the maximum. However, this carries a condition. In order for those contributions to be compliant, you must remain eligible for an HSA for 12 months (the "testing period"). So if you switched to an HDHP on October 1 and took advantage of the last month rule by maxing out your HSA, you would need to stay with an HDHP until the following October 1. If you didn't, you would need to withdraw the overcontribution, and you would owe income taxes as well as a 10% tax penalty. The last month rule applies in the same way when switching between single coverage and family coverage.
A rollover is a transfer of money (or assets) between two tax-advantaged accounts that are not the same type. The most common rollover is between a 401(k) and an IRA. When money is moved between tax-advantaged accounts of the same type, that's a "trustee-to-trustee transfer". The most common transfers are between two IRAs or two 401(k) accounts.
When you leave an employer, you can move the money to your new employer's plan or move it to your own IRA. If your account is large enough, you may also be able to keep it in your old employer's plan. Your IRA is generally the best option. An IRA gives you much broader options for investments, has no account-based fees, and lets you choose your custodian (usually a brokerage firm like Fidelity). There are a few potential benefits to choosing your employer's plan instead: it may have better creditor protection than an IRA (depending on your state) in the event of bankruptcy; in rare cases, it may grant you easier access to investments that wouldn't be available in your IRA (but usually the investment options are worse); and it permits you to take out "loans" from the account, as discussed in this footnote.[3] Some people may want to avoid placing anything in a traditional IRA in order to facilitate a backdoor Roth contribution (which is discussed in the section on taxes). For most people, the benefits of an IRA greatly outweigh the potential benefits of an employer-sponsored account.
When performing a rollover from an employer plan to an IRA, you'll generally want to avoid tax implications. To avoid a taxable event, you can roll over a traditional 401(k) account to a traditional IRA, or a Roth 401(k) account to a Roth IRA. You can also open a rollover IRA, which is identical to a traditional IRA except that it facilitates a rollover into a new employer's plan. The paragraph above described why this is not ideal for most people. If you plan to keep the money in your own IRA, you can roll it over to a traditional IRA instead. Your traditional IRA may already have money in it if you've made prior contributions. Rolling money into an IRA has no effect on the account's contribution limit.
Money can be rolled over or transferred by performing a "direct rollover" or an "indirect rollover". A direct rollover is far simpler and carries very little potential for error. The entire process is the following: If you don't already have an IRA with the appropriate plan — traditional or Roth — open an IRA with the broker that you'd like as your new IRA custodian, such as Schwab or Fidelity. Call the current custodian of your employer plan, and tell them you'd like to perform a direct rollover to an IRA. Have your new account number ready and the custodian's address to which the check (yes, the physical check) should be sent. Your current custodian will transfer the money directly to the new custodian. An even easier alternative is asking your new custodian to request a rollover, and they'll do all the work for you.
In contrast, when you perform an indirect rollover, you receive the money yourself and must deposit it in the new account within 60 days to avoid tax implications. Unfortunately, 20% of the amount is withheld in case federal taxes are triggered, and you have to make up the 20% out of your own savings until your federal refund arrives (or face taxes and potential penalties). On top of this, you can perform only one indirect rollover in any rolling 12-month period. The complexity and potential for error is why I don't recommend indirect rollovers.
You can also transfer money between IRAs if you'd like to change custodians or consolidate your accounts. The process is very similar. This would involve transferring between two traditional IRAs or two Roth IRAs. Rolling over money from a traditional IRA to a Roth IRA is a distinct process, because it's a taxable event. When you perform a Roth conversion, the amount rolled from a traditional account to a Roth account is added to your taxable income. The appropriate circumstances for a Roth conversion are discussed in the "Roth or traditional?" section. It is not possible to transfer money from a Roth account to a traditional account.
We'll cover the motivations for transferring money between HSAs in a later section.
Roth IRAs have two somewhat distinct "five-year rules". The first is simple: you can't withdraw earnings from a Roth IRA until five years after your first contribution to a Roth IRA. If you turn 57 in 2024 and make your first Roth IRA contribution in the 2024 tax year, you can't withdraw earnings penalty-free until Jan 1 2029, even though you reached age 59½ at an earlier date. You can always withdraw your cumulative Roth IRA contributions penalty- and tax-free. Most investors don't have this issue, since they start contributing to a Roth IRA before their 50s.
The second five-year rule is related. In a Roth conversion, you transfer assets from a traditional account to a Roth account. You can't immediately withdraw the converted funds penalty-free, like you can with direct contributions. If the conversion is done anytime in the 2024 tax year, the five-year delay starts on Jan 1 2024, and those funds could be withdrawn penalty-free on Jan 1 2029. If another conversion is done the following year, that money can't be withdrawn until 2030.
With an inherited Roth IRA, the beneficiary has the same relationship to these rules as the original account owner. To avoid penalties, the beneficiary should wait until five years after the first contribution's tax year, and the beneficiary shouldn't withdraw funds from a Roth conversion until the converted funds have aged five years.
A 529 account is for the educational expenses of a specific beneficiary. Contributions to a 529 account are not tax-deductible at the federal level, but a majority of states provide deductions under certain conditions. Investments grow tax-free and qualified distributions used for education are not taxed. There are no annual contribution limits, but each state places its own limit on the sum of all contributions. You need to research the investment options available to you before opening an account. An IRA or HSA can offer almost as much freedom as a standard brokerage account, but the options for your 401(k) or 529 account may be far less attractive. An adult acts as the custodian of a 529 account, but the beneficiary can assume control after reaching age 18. The account can not only pay for direct educational costs like tuition and books, but also indirect costs like off-campus housing and computers. If distributions are not used for qualified educational expenses (and don't meet conditions for an exception), investment earnings are subject to income taxes and a 10% federal tax penalty. If there is leftover money, one way to avoid paying these taxes is to change the beneficiary. You can also roll up to $35K from a 529 account to the beneficiary's Roth IRA under certain conditions (one of which is that the account must be at least 15 years old). US Treasury savings bonds are exempt from tax if rolled into a 529 account within 60 days of redemption (and income requirements are met).
Despite all the features I’ve celebrated about HSAs, there is some potentially bad news. HSA contributions are tax-deductible with regard to federal income tax, FICA taxes, and state taxes in most but not all states. There are two holdouts: California and New Jersey. In these two states, HSA contributions and earnings receive no state tax breaks. Despite the federal government designating HSAs as tax-advantaged accounts about 20 years ago, CA and NJ do not agree and will tax you like you’re investing in a taxable account. If you plan to live in either of these states for a long time, the arguments I’ve made about HSA investing are far weaker, because they have some of the highest taxes in the country.
Separately, New Hampshire has a mild tax which doesn't amount to a major drawback of HSAs in that state. NH taxes interest and dividends that exceed $2,400 for single filers and $4,800 for joint filers. Surprisingly, interest and dividends in your HSA are included. However, since NH doesn't tax capital gains, the effect of this tax on your returns will be negligible unless you have a very large portfolio. For people with taxable portfolios smaller than $200K, this is likely to trigger zero tax. Tennessee had a similar tax until 2021. Feel free to write to representatives in these three states, especially CA and NJ, encouraging them to repent.
If you invest in your HSA and move to CA or NJ, you could buy US Treasury bonds to avoid state tax because they're taxed only at the federal level. Since your HSA is federally tax-advantaged, US Treasury bond funds in your HSA would not be subject to any tax.[4] The benefit of avoiding state tax would have to be weighed against the drawbacks of not investing in your preferred HSA portfolio.
Traditional IRAs and other tax-deferred retirement accounts have required minimum distributions (RMDs). The government wants you to pay income tax on that tax-deferred money eventually, so in your old age they compel you to withdraw a fraction of the IRA's value that depends on your age and population-level expected lifespan. The age at which RMDs begin was 70½ until 2020, when it rose to 72. Congress raised it to 73 starting in 2023, and it will increase to 75 in 2033. Based on IRS tables that give a "distribution factor" for each age, you divide the value of your traditional IRA on Dec 31 of the previous year by the distribution factor to give the dollar amount of the RMD. The distribution factor decreases with higher age, so the fraction you must withdraw increases every year (until the factor stops changing after age 120). For this purpose, your age in a given year is your age on the last day of the year.
The deadline for the first RMD is Apr 1 in the year after you turn 73. For the RMDs in all subsequent years, it is Dec 31. Everyone born in 1951 turns 73 in 2024, so they need to take their first RMD by Apr 1 2025, based on the account value on Dec 31 2023 and the distribution factor for age 73. Their second RMD due by Dec 31 2025 will be based on the account value on Dec 31 2024 and the distribution factor for age 74, and so on. Many institutions calculate your RMD for you and may even offer to automate the withdrawals. Investor.gov has an RMD calculator here.
RMDs up to $100K can be donated to charity in a tax-deductible manner if you already want to donate the amount, and would like to avoid the income taxes that they would otherwise trigger. Roth IRAs do not have RMDs, because taxes on that money were fully paid when you contributed to the account. If you've reached age 73 and you're still working, you don't need to take RMDs from your employer's retirement plan until Apr 1 of the year after you retire.
HSAs have another subtle advantage over traditional IRAs: they don't have RMDs. But most retired people don't regard RMDs as an unnecessary tax burden. They need to withdraw money anyway! So withdrawing at least the amount dictated by the RMD is uncomplicated for the average person who's living off Social Security, their modest IRA, and perhaps a pension.
If charitable donations will be an important goal in your old age, traditional IRAs have a clear advantage over Roth IRAs. The untaxed contributions and investment earnings in your traditional IRA can be donated tax-free after age 70½. Money in your Roth IRA has already been taxed and is ideally suited for personal spending. Your HSA is poorly suited to donations while you're alive (as well as inheritance), so it's best used for personal spending after 65 if the amount exceeds anticipated health care spending. Your spouse can inherit your HSA with no tax paid — the funds are absorbed into their HSA — but any other personal beneficiary would have to pay tax on the full amount in the year of your death. If you donate to charity with HSA funds while you're alive, you still have to pay tax on those withdrawals. However, if the beneficiary of your HSA is a charity, there is no tax due when they receive the funds upon your death. Both traditional and Roth IRAs are better-suited to leave to children or other persons. None of these concerns should be a dominant influence on how much money you choose to spend or donate, but considering them will increase your wealth and the wealth of your beneficiaries.
A donor-advised fund enables tax-exempt investing for charitable donations. Contributions to a DAF are tax-deductible to the same degree that direct donations would be. Once you contribute the money to your DAF, that money is no longer yours to spend. It's legally destined for IRS-qualified 501(c)(3) organizations. But you can invest the money before granting it to a charity. Significant fees are charged by DAF sponsors like the non-profit arms of Fidelity and Schwab. Unless your account balance is above $500K, Fidelity and Schwab annually charge the greater of $100 or 0.6% of the account. So to minimize fees as a percentage of your account, the initial contribution to a DAF should be at least $16,667. A $300 DAF would be eaten alive by fees in a few years, so unfortunately those who can't afford to donate large amounts should not invest in a DAF.
Even those who can contribute large amounts should consider whether the tax deduction and tax-exempt investing are enough to overtake the annual fee, which decreases only for amounts greater than $500K. In the absence of a low-fee sponsor, the situations in which a DAF is suitable are rare (although some people surely use one without realizing this). Imagine if the only way to invest in stocks were to buy shares of a fund with an expense ratio of 8% — investing would no longer be feasible. The DAF fees are roughly that bad for typical users.
A DAF can be helpful when someone receives a windfall and would benefit most from taking the tax deduction immediately, but doesn't want to decide where to donate all that money before the end of the year. Tactics for optimizing your donations are discussed in the section on taxes.
A DAF can also be used when donating shares with unrealized gains (to maximize the tax deduction) to a charity that can't accept securities. You would donate shares to your DAF, sell the shares, and immediately grant the entire cash amount to the charity, paying very little in fees. This is the most common way a DAF can be used for real benefit.
Daffy is an organization launched in 2021 that offers a DAF for as little as $3/month, with low-cost investing options. They were covered by the WSJ, and the co-founder and CEO was interviewed on Meb Faber's podcast and The White Coat Investor podcast. It will be interesting to see if their model is sustainable.
A DAF is better than a private charitable foundation for almost all charitable purposes.
In the section on fund selection, we discuss how to navigate restrictive and fee-laden employer retirement plans.
There is essential information on tax-advantaged accounts in the section on taxes. It's deferred because the tax essentials introduced first in that section are a prerequisite. Below that is a discussion of how to think about contributing to Roth or traditional accounts. Another subsection on tax-efficient investing emphasizes how much it helps your returns to invest in tax-advantaged accounts, and how important it is to contribute as much as possible as early in life as possible.
Contributions to a traditional account are tax-deductible, but you pay income tax when you withdraw. Contributions to a Roth account are not tax-deductible, but you pay no tax when you withdraw. Consider exploiting the unique, under-appreciated advantages of HSAs. Max out employer matching even if you have debt, with awareness that if you change employers it is possible to lose some 401(k) matching due to your vesting schedule.
The benefits of HSAs are:
- Tax-deductible contributions, tax-free investment, and tax-free qualified distributions.
- The ability to spend on health care from your checking account (while getting credit card rewards if you use a credit card), and reimburse yourself from the HSA in the future. With enough reimbursible expenses incurred over time, your HSA becomes a tax-free investment account that you can withdraw from if needed at any time, penalty- and tax-free.
- HSA contributions through payroll deduction avoid income taxes and FICA taxes. Contributions to traditional IRAs and employee contributions to traditional 401(k) accounts avoid only income taxes. See this footnote on employer contributions to 401(k) accounts.
- The ability to withdraw penalty-free for non-medical reasons after age 65 (like a traditional IRA), but having still avoided FICA taxes on the front end and with no RMDs. Investing in an HSA is strictly better than doing so in a traditional IRA unless (a) you withdraw the money prematurely, (b) you want to donate the money before death, (c) you plan to leave the money to a non-spousal person upon death, or (d) you're a CA or NJ taxpayer.
- Qualified distributions include medical expenses for your spouse and dependents. During old age, qualified distributions include paying for long-term care insurance premiums and some Medicare premiums.
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All sections:
- Cover page
- Introduction to index funds
- Thinking about risk
- Tax-advantaged accounts
- Your psychology
- Investing for retirement
- Guidelines for personal finance
- Building a stock portfolio
- Fund proposals
- Advice
- Practical information for execution
- Taxes
- Vocabulary and further resources
- Advanced topics
Footnotes:
1 Employers owe payroll taxes, and while invisible to the employee, this is an additional cost of employing each person. Employers pay the same federal payroll taxes: 6.2% Social Security tax and 1.45% Medicare tax (so FICA taxes are actually 15.3% in total, not 7.65%). Contributing to your HSA means that both you and your employer avoid paying FICA taxes on that amount. Employers also pay state unemployment taxes (SUTA) and federal unemployment taxes (FUTA), which fund unemployment benefits. There are only a few states in which employees also contribute to state unemployment benefits. Employers may owe local taxes as well. ↩
2 The only contributions to a 401(k) account (or another employer-sponsored retirement account) that avoid FICA taxes are employer contributions. Employee contributions are subject to FICA taxes. Until 2023, employers could not contribute to your Roth 401(k), but they can now make both traditional and Roth contributions. ↩
3 Hardship withdrawals and 401(k) "loans"
Retirement accounts are not completely inflexible with regard to accessing funds before age 59½. They allow hardship withdrawals: penalty-free distributions for expenses that meet specific requirements. Reasons for hardship withdrawals from a work retirement plan include educational expenses; costs up to $10K for buying a primary residence if you haven't owned a home in at least two years; payments needed to prevent eviction; and medical expenses that exceed 10% of your adjusted gross income (we'll define adjusted gross income in the section on taxes). Work retirement plans set their own terms, so they may have restrictions on top of those from the IRS. The potential reasons one can cite for a hardship withdrawal from an IRA are narrower: educational expenses, buying a primary residence, and health insurance premiums if you’re unemployed. Hardship withdrawals are subject to income tax even though they're penalty-free, so tax will be withheld.
In addition, you’re legally permitted to take out a “loan” from your work retirement account (it's not permitted with an IRA). You borrow your own money from the account with the expectation that you'll repay the principal amount plus interest. You then pay the loan over (usually) no more than five years. Of course, this isn’t actually a loan: a real loan requires a lender and a borrower that are different parties, generally involves a credit check, and carries legal obligations of repayment. The distinction is clear but, as Michael Kitces attested in this interview, some people are so confused about the use of the term “loan” that they think they can effectively invest in a high-yielding bond by taking out a 401(k) loan.
What are the benefits and drawbacks of using a retirement plan “loan”?
You can borrow up to 50% of your vested account balance. However, if the balance is less than $10K, you can borrow your entire balance, and if the balance is $10K-$20K, you can borrow $10K. The amount can’t exceed $50K regardless of your account balance. Check with your plan to see if they have further restrictions. Your plan provider is not required to allow loans at all, as long as their policy is consistent across all plan participants. Loans for the purchase of a primary residence can be paid back over more than the typical five years. The maximum allowed time for a primary residence loan isn’t dictated by law so, again, ask your plan provider for details.
Loan repayments don’t affect the account’s contribution limit. To some people, that sounds like loans are a smart way to increase the effective contribution limit and move more money into a tax-advantaged account. But the opposite is true. The interest contributed to the account is not tax-deductible, but you still have to pay tax on it when you withdraw. Every dollar of interest paid on a 401(k) loan is a dollar volunteered for double taxation.
Imagine we take out a $40K loan from a traditional 401(k) at 6% APY and pay it back on a monthly basis over five years. We’ll repay the principal of $40K, of course, as well as more than $6K of interest. The principal was removed from the 401(k) with no tax implications, and repaid to the account with no tax implications. So there are no negative consequences there. However, we received no tax deduction for adding over $6K of interest to a traditional account. We paid income and payroll taxes on the $6K before depositing it. And when we finally withdraw that money, we’ll pay income tax on it again!
I think most people who take 401(k) loans don’t appreciate this drawback. Notably, it doesn’t apply if you borrow from a Roth account, but most people don’t have large Roth 401(k) balances (and some employer plans don’t even offer a Roth option).
If the loan isn’t paid back in full, there is no default that harms your credit score. The outstanding loan balance is deemed a distribution from your account. So you don’t have to pay it back, but you will owe extra taxes if you don’t. If you intend not to pay it back because you need the money and can’t repay it, you can just withdraw from the account without bothering to take a loan.
If you leave your employer, the loan has to be paid back on a potentially accelerated schedule. If you left your job in 2024, the full loan balance would be due by tax day in 2025 (roughly April 15). So the full loan could suddenly be due in a year and change, or as little as four months. This presents an obvious problem: people who lose their jobs are generally the least capable of quickly repaying a loan. And if they accept that they can't repay it, they'll have an extra large tax bill waiting for them anyway.
What are the extra taxes triggered by unpaid loans? They're the same as if you had withdrawn money from the account. An unpaid loan from a traditional account would be subject to income tax and, if your age is less than 59½, a 10% federal tax penalty. With a Roth account, you would owe income tax and the potential 10% penalty, but the tax would be applied only to the account's earnings. Earnings in a Roth account are the account value minus the cumulative contributions. Because you’ve already paid all taxes on contributions, only earnings can be taxed. So if a Roth account had 60% contributions and 40% earnings, tax would be applied to 40% of the deemed distribution.
How do 401(k) “loans” compare to conventional loans?
With a 401(k) loan, you pay no actual interest because you’re borrowing from your own account; and your credit score is not damaged if you fail to repay, but you owe extra tax. However, the loan amount is limited by your account balance; you potentially miss out on high investment returns in a tax-protected account; you risk accelerated repayment if you lose your job; and the interest paid to a traditional account is subject to double income tax.
With a conventional loan, you pay interest and your credit would be affected by default. But there is no strict limit on the loan amount; you allow your tax-protected retirement assets to stay invested with a high positive expected return; and repayment terms don’t change if you lose your job.
Can 401(k) loans serve a useful function? Yes. But there are better alternatives if you plan ahead. You can save and invest in taxable accounts for large financial goals that precede age 59½. You can build an emergency fund for surprise expenses. If your emergency fund is depleted, you can also draw on Roth IRA contributions and HSA-eligible expenses that haven’t yet been reimbursed. Both of these allow you to withdraw from tax-advantaged accounts penalty- and tax-free. There are credit cards that charge zero interest for periods such as 18 months. These could serve as liquidity for those with good credit, as long as you’re confident you can pay off the debt before interest is charged. ↩
4 There are a few other investments that would avoid state tax. One is municipal bonds issued by your state. Income from muni bonds is tax-free at the federal level, and tax-free at the state level if the bond is issued by your home state (or by any US territory). You could invest in a fund like DFCA in California or FNJHX in New Jersey, or you could buy the bonds directly since expense ratios are higher than for typical bond funds. But I would argue that US Treasury bonds are preferable because they have minimal credit risk, you can invest with very low-cost funds, and they don't exhibit the weird dynamics that follow from the tax-exempt status of muni bonds. In addition, it's glaringly suboptimal to buy federally tax-exempt bonds in a federally tax-advantaged account. Muni bonds have a lower yield than they otherwise would because they're federally tax-exempt. Another type of investment is any security that doesn't have distributions. Unfortunately there are no US-listed stock or bond funds that lack dividends, but there are stocks that have never paid a dividend like AMZN, BRK-B, META, EW, and BKNG. I mention this only as a hypothetical possibility, because I wouldn't suggest buying individual stocks to most people. Finally, although all US-listed stock and bond funds have distributions, precious metal funds like GLD do not. However, I don't recommend investing in gold, even within a more diversified portfolio. ↩