You’re ready to start saving for retirement, but there are several different accounts you could use. Brokerage accounts, IRAs, Roth IRAs, 401(k)s. Where should your retirement savings go, and why?

Retirement Account Types

Broadly, there are three categories of retirement accounts, called “taxable”, tax-deferred", and “tax-free”.

First, you could just open a regular brokerage account to buy index funds (or individual stocks, or other mutual funds). These are just like a regular bank account. You put in regular after-tax money, and you pay tax on any dividends you earn every year. When you sell shares of a fund, you also pay capital gains tax on any gains since you bought it. You can put as much money in as you want, and take it out whenever you want. These accounts are “taxable” accounts, since they just follow the same tax rules as a regular bank account.

If you save in an IRA, 401(k), or 403(b) instead, you get some bonuses. First, you get to deduct your contributions from your taxable income. If you are in the 25% tax bracket and you put $1,000 into an IRA, you put in $1,000 but then get $250 off on your federal taxes. Overall, you got $1,000 in retirement money for only $750 less in after-tax income. Even better, any dividends or gains you get inside these accounts doesn’t get taxed, so they grow as much as possible. There is a downside, however - you have to pay tax on all of the money you take out as if it was normal income. You also (normally) can’t get the money out until you reach age 59.5. There are limits to how much you can put in each year. These accounts are “tax-deferred”, because you defer any tax on the money until you take it out.

You can also save in an account called a Roth IRA. Like the IRA, any dividends or gains in the account are tax-free. Unlike a normal IRA, though, the contributions are not deducted from your taxes. In exchange, when you take the money out, you pay no tax at all. You can’t take any growth in the account until age 59.5, but you can take out your original contributions any time. Some 401(k) accounts also let you make “Roth contributions” to them, which act just like a Roth IRA. These accounts are “tax-free”, because you pay no tax on the growth from them.

Which is Best?

Which account type should you use? As I’ve said earlier, your taxes are usually much lower when you retire. So, most people should use a tax-deferred account like a 401(k) or IRA first, getting a big tax discount now rather than a smaller one later.

For an IRA, you may only contribute a certain amount per year ($6,000 in 2021, or $7,000 if you are age 50 or older) and you may only contribute if your income is under a certain limit ($198,000 for a married-filing-jointly couple in 2021).

For a 401(k), there is also an annual contribution limit ($19,500 in 2021, or $26,000 if you are 50+), but no income limit.

After you’ve filled up your tax-deferred options, look for tax-free options next. The IRA contribution limit is shared with Roth IRAs, so if you contributed as much as you’re allowed to an IRA, you can’t contribute anything to a Roth. While there is an income limit for Roth IRA contributions, there’s a weird tax rule which allows you to contribute after-tax to a regular IRA and then move that money into a Roth IRA. This is called a “backdoor Roth” contribution.

If your 401(k) allows “after-tax contributions” (separate from regular and Roth contributions) and “in-service distributions”, you can contribute money over the normal 401(k) limit as “after-tax” contributions and then ask your company 401(k) provider to turn it into a Roth 401(k). This is called a “mega backdoor Roth” contribution. There is a limit to how much your 401(k) contributions plus any company match plus any after-tax contributions can be ($57,000 in 2021), so the limit for just your after-tax contributions depends on that.

If you’ve hit the tax-deferred and tax-free contribution limits and still have more to save (bravo!), it’s finally time to contribute to regular taxable accounts.

Special Cases

I’ve said taxes are usually much lower in retirement. If, for some reason, you expect higher taxes in retirement, save in tax-free accounts first.

If you have money you want to save for retirement but might need it sooner, you can save in a taxable account so that you can get the money early if you need it. For example, if you’re worried that the college fund for your kids won’t be enough, you could put some savings in a taxable account for easy access if needed.

Finally, if you’re getting close to retirement and will retire before age 59.5, you should save up for the last few years in a taxable account. Basically, you can get money from tax-deferred and tax-free accounts before age 59.5, but you need a few years of spending in a taxable account to get things started.

Which Investments in Which Accounts?

So, if you decide you want 75% stock and 25% bonds, should each of your accounts have exactly that ratio? Well, no.

First, let me say that if you only have one kind of account (all tax-deferred), you don’t have to worry about this. It’s also not a big deal until your account balances get relatively large. (So you don’t need to figure this out to get started.)

That said, money you take out of a tax-free account is tax-free, money from a tax-deferred account is taxed at high rates, and money from a taxable account is taxed at moderate rates. You ideally want your fast-growing investments (stock) in your tax-free accounts, and your slow-growing investments (bonds) in your tax-deferred accounts.

In your taxable accounts, interest from bonds is taxed at a high rate, while dividends and gains from selling stock are taxed at a lower rate. So, if all of your bonds fit in your tax-deferred accounts, great. If not, consider tax-exempt bonds in your taxable account.

Another consideration is “rebalancing” - exchanging one investment for another to keep your target stock and bond percentage consistent. If you rebalance in a taxable account, you have to pay taxes on any gains from stock you sell. You might end up keeping some stock in your tax-deferred accounts just so that you can do your shuffles there.

These tactics can help optimize your taxes somewhat, but don’t let these considerations keep you from having the percentage of stocks and bonds you feel comfortable with. If you want more bonds than you have room in your IRA for, buy them. Don’t let the “tax tail wag the dog” as they say. Also, if you have enough retirement savings that the interest and dividends are causing you a lot of taxes, it’s a very good sign for your retirement. =)