Which investment option is most likely to reduce an individual's tax burden at retirement? (2024)

Which investment option is most likely to reduce an individual's tax burden at retirement?

Roth IRA or Roth 401(k) qualified distributions are tax-free. Social Security income is taxed at your ordinary income rate up to 85% of your benefits; the rest is tax-free.

Withdrawals of any earnings from your Roth IRA investments are tax-free and penalty free if you've satisfied the five-year holding period and you're age 59½ or older.

Roth IRA: A Roth IRA is an "after-tax" account, meaning that you don't get a tax deduction for Roth contributions. However, your investments in a Roth IRA will grow free of tax until your retirement, and any qualified withdrawals from the account will be 100% tax-free.

A Roth IRA isn't an investment itself, but a retirement account for tax-free investing. With a Roth IRA, you contribute after-tax dollars to your account, up to the annual limit. For 2024, the limit is $7,000 (up from $6,500 in 2023), plus an additional $1,000 catch-up contribution if you're 50 or older.

Contribute as much as you can to your retirement plan

Your employer may offer a 401(k), 403(b) or other retirement savings plan. Contributions to these plans may be made pretax, which means they will reduce the amount of your income that is subject to tax for this year.

Two of the most commonly-used tax-exempt accounts in the U.S. are the Roth IRA and Roth 401(k). Contribution limits for Roth IRAs and Roth 401(k)s are the same as for traditional IRAs and 401(k)s.

Examples of tax-advantages accounts are IRAs, 529 college savings plans, health savings accounts (HSAs) and 401(k) plans.

Examples of tax-advantaged investments are municipal bonds, partnerships, UITs, and annuities. Tax-advantaged plans include IRAs and qualified retirement plans such as 401(k)s.

Which is the best tax-free investment?

Although tax-exempt mutual funds usually produce lower yields, you generally don't have to pay federal taxes on earnings from tax-exempt money market and bond funds. And you can save even more if you live in a state that offers similar exemptions.

Earnings can't be withdrawn tax-free until age 59½ and the account is at least 5 years old. Diversification in retirement, so all of your accounts aren't tax-deferred. The maximum contribution is relatively low compared with a 401(k). You'll probably need other accounts to save enough for retirement.

The IRS categorizes the IRA deduction as an above-the-line deduction, meaning you can take it regardless of whether you itemize or claim the standard deduction. This deduction reduces your taxable income for the year, which ultimately reduces the amount of income tax you pay.

Roth 401(k)s reduce taxes later

Unlike a tax-deferred 401(k), contributions to a Roth 401(k) do not reduce your taxable income now when they are subtracted from your paycheck.

Key Takeaways

Contributions to a traditional IRA can reduce your adjusted gross income (AGI) for that year by a dollar-for-dollar amount. If you have a traditional IRA, your income and any workplace retirement plan you own may limit the amount by which your AGI can be reduced.

What retirement account do you not pay taxes on?

Taxes on IRAs and 401(k)s

You can find instructions for calculating what you owe in IRS Publication 590, Individual Retirement Arrangements. If you have a Roth IRA, you'll pay no tax at all on your earnings as they accumulate or when you withdraw following the rules.

Retirement tax rates by income source

Roth IRA or Roth 401(k) qualified distributions are tax-free. Social Security income is taxed at your ordinary income rate up to 85% of your benefits; the rest is tax-free.

Employee contributions can reduce current taxable income. Contributions and investment gains are not taxed until distributed. Contributions are easy to make through payroll deductions. Interest accrues over time, which allows small, regular contributions to grow to significant retirement savings.

The Three Bucket strategy is a popular financial planning method for those working towards financial independence. The strategy involves dividing your assets into three distinct "tax buckets": tax-deferred, tax-free, and after-tax.

An IRA offers investors a tax-advantaged way to build the value of their investments during their working years. A traditional IRA offers investors tax-deferred growth, while a Roth IRA offers investors tax-free growth and withdrawals, after paying taxes on the money contributed.