Summary/TL;DR
Pre-tax retirement accounts allow savers to defer taxes on contributions today in exchange for taxation in retirement. Roth accounts reverse this, with contributions taxed today in exchange for no taxation in retirement. And non-qualified accounts have no tax advantages, but are far more flexible than pre-tax and Roths. When it comes to deciding which option is the “best” for you, key variables to consider include your goals for the funds you’re saving, your income, and your age.
Introduction
Optimizing your saving and investing plan for tax-efficiency can save you hundreds of thousands in taxes throughout the course of your lifetime. Unfortunately, the optimization process is not as straightforward as one would hope, as there are multiple options for how one can choose to be taxed on their savings. Furthermore, the “best” option for you today will not likely be the “best” option for you later in life.
In today’s post, I’ll discuss what these options are and some principles for deciding how you can choose between them.
The Different Types of Accounts and How They Are Taxed
Pre-tax (Traditional) IRAs/401(k)s
“Pre-tax” accounts include Traditional IRAs and almost any employer retirement account that doesn’t have the word “Roth” in front of it.
Pre-tax accounts get their name from the fact that funds saved into them are not taxed at the time they are saved. In other words, they are saved before (“pre”) taxation. These funds remain untaxed until they are distributed in retirement, at which point the entire distribution is taxable. Distributions from these accounts become mandatory at age 73-75, depending on your birth year. These mandatory distributions are called Required Minimum Distributions, or RMDs.
Roth IRAs/401(k)s
Roth accounts are just the reverse of “pre-tax” accounts. When funds are deposited into a Roth account, they will still be included in your taxable income. However, Roth accounts remain tax-free forever after your original contributions (growth and all) as long as you follow a few IRS rules.
Non-Qualified Accounts
These accounts get their name from the fact that they are, simply, not “qualified” accounts like the ones discussed above. A qualified account is generally any investment account that qualifies for a tax-advantage contingent on certain rules being followed. A non-qualified account, then, is an account that does not qualify for any tax breaks, but also has the advantage of having no strings attached. Non-qualified accounts are also referred to as “taxable” accounts, or sometimes “brokerage” accounts.
When funds are saved into a non-qualified account, they will still be included in your taxable income. When funds are sold (not necessarily distributed) only the growth is taxable. If funds are sold at a loss, this may reduce your taxes. Generally, if you’ve held the stock for less than a year, the gain will be taxed at your ordinary income rate. If, however, the stock is held for a year or longer, then the gain will either be completely tax-free or taxed at a flat rate of 15% or 20% depending on your overall taxable income.
Which To Save Into
The presence of multiple options for savers beg the questions, “which is the best for me, and will it change over time?". These questions are ultimately answered by a combination of your goals, age, and income.
What Are Your Goals?
Clearly, pre-tax and Roth accounts are only appropriate for retirement savings, which is normally considered “long-term”. Anything that’s not being saved for the purpose of retirement is best saved in a non-qualified account.
Pre-tax and Roth accounts also have annual contribution maximums, so those wanting to save for retirement might find non-qualified accounts to be their best option if they want to save beyond these maximums.
Age and Income
Arguably the most important variable in this decision is your income, as this is what will determine your tax bracket. Below are the income tax brackets for 2025:
Generally speaking, the 24% tax bracket is considered to be the last point at which it’s favorable to forgo pre-tax accounts in favor of Roth. This is because the bracket below the 24% tax bracket is 22%, which is “only” 2% lower than 24%, while the bracket above the 24% bracket is 32%, a massive 8% jump. Furthermore, the income range for the 24% bracket is quite large, covering almost $100,000 for single taxpayers and $200,000 for married tax payers. Finally, 24% is a relatively low tax-rate if the history of the income tax is taken into consideration.
Due to the tax-free nature of Roth accounts, however, younger investors will benefit disproportionately from investing earlier in their careers. Someone who contributes $10,000/yr to their employer’s Roth 401(k) starting at age 25 will have amassed a $2.7M tax-free retirement account by the time they’re 60, while someone starting at age 40 will have saved “only” about $570,000 by this same time.
Fortunately, these two variables relate to each other in a convenient way. Most workers will find that their incomes are the lowest that they will ever be in their 20-30s, which are also the ages at which they will benefit the most from contributing to tax-free accounts. Furthermore, earnings tend to peak around the age of 45-50 and slow from there, which are also well past the years which Roth savings become disproportionately beneficial due to age. Given this pattern, it will be best for most to invest into their Roths in their 20s-30s and begin to think about pre-tax accounts in their 40s and beyond. It can also be the case that Roth accounts continue to be appropriate beyond this point, but this has more to do with tax rates at the time and what one’s overall retirement plan looks like.
Talk To A Professional
Making the "right" decision regarding which type of account to save into is not an easy one and will change over time. Working with a qualified professional who understands your circumstances and the tax code can save you a lot of time, stress, and money in the long run!
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