Medical expenses

3 Accounts Guaranteed to Minimize Your Taxes In Retirement

One of your biggest expenses in retirement could be your tax bill, but using these three accounts will help ensure that you can keep more of your savings for yourself.

When you contribute to an HSA, Roth IRA, or Roth 401(k), you’re setting yourself up to take tax-free withdrawals in the future. What’s more, qualified withdrawals from those accounts won’t count toward your adjusted gross income. This can affect taxes on Social Security and Medicare premiums, helping you keep even more of your money. Here’s how these three accounts work, and how they might fit into your retirement plan.

1. HSA

An HSA, or health savings account, is a special account designed for people enrolled in a qualifying high-deductible health insurance plan.

If you’re eligible for an HSA, it’s one of the best accounts you can use for retirement savings. Your contributions are tax-free, plus you’ll save on your FICA taxes if you make contributions directly from your payroll.

The account is designed to help pay for medical expenses as they occur. But, if you have the means, you can pay for those expenses with other funds, and allow your investments in your HSA to grow indefinitely. Better yet, you won’t pay any taxes on capital gains or dividends in the account.

When you’re ready to take a distribution, you won’t pay any taxes on withdrawals reimbursing qualified medical expenses. As mentioned, those expenses can occur years earlier, as long as you had an HSA open at the time of the expense. That can make the account completely tax-free for retirees.

A person cutting a piece of paper with the word Taxes printed on it.

Image source: Getty Images.

2. Roth IRA

A Roth IRA is available to anyone with earned income, and it can be a great way to save extra money for retirement.

Contributions to a Roth IRA don’t provide a tax deduction like its traditional counterpart. However, you get the same tax protection for the investments in the account — no taxes on capital gains or dividends. When you take a distribution, you won’t pay any taxes at all, as long as you’re over the age of 59 1/2.

You won’t be eligible to contribute to a Roth IRA if you earn above a certain threshold — $153,000 for individuals and $228,000 for couples in 2023. You may, however, be able to use the backdoor Roth IRA to work around the limit and get money into a Roth IRA.

The Roth IRA comes with the added benefit of being able to withdraw contributions tax-free at any time. So, if you put money into your account today, and have an emergency that you simply cannot cover any other way, the Roth IRA offers added liquidity. That said, you’ll want to avoid withdrawing early if you can.

3. Roth 401(k)

If your employer offers a Roth option for its 401(k) plan, it provides another option for tax-free retirement savings.

A Roth 401(k) is very similar to a Roth IRA, but there are a few nuances you should be aware of. You may be limited in your investment choices with a 401(k), whereas a Roth IRA will allow you to invest however you choose. Similarly, you’ll be stuck with the 401(k) provider your employer uses, whereas you fully control your Roth IRA and can move it to any provider you choose. Additionally, you may be subject to administrative and other fees for the 401(k).

Unlike a Roth IRA, you also can’t easily access your contributions early if you need to. Withdrawals from a Roth 401(k) are prorated between contributions and earnings, meaning at least some of each withdrawal will be subject to taxes and penalties. You can, however, use the 401(k) loan provision to access up to $50,000 from your account without withdrawing funds.

On the plus side, there’s no income limit for a Roth 401(k), so you can easily contribute to the account no matter what. Employer matching contributions can also go into your Roth account, following the passage of the SECURE 2.0 Act.

Keep your taxes low in retirement

The mechanism by which withdrawals from the above three remain tax-free is extremely powerful in retirement. Distributions do not add to your adjusted gross income.

That’s important because your AGI is used for more than just taxes in retirement. It’s used to calculate your Medicare Part D premiums or Affordable Care Act subsidy if you retire early.

What’s more, keeping your AGI low gives you the flexibility to use other accounts like a traditional retirement account or taxable brokerage and still pay very little in taxes. If you withdraw up to your standard deduction from a traditional retirement account and stay under the threshold for 0% capital gains taxation, you can live a completely tax-free retirement fueled by one or more of the above three accounts.

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