Tax-deferred accounts
The 401(k) and traditional IRA. No tax going in, no tax along the way, ordinary income on the way out.
You contribute before tax, so a dollar of salary becomes a dollar in the account rather than whatever is left after withholding. It then grows untouched for decades. Every dollar withdrawn is ordinary income at your normal graduated rate.
That last part is the one people forget. A tax-deferred account converts what would have been capital gains into ordinary income, which is taxed at a higher rate. It is still usually worth it, because decades of untaxed compounding outweigh the worse rate at the end, but it is the reason these accounts are the right home for assets that would be taxed as ordinary income anyway.
It is deferral, not forgiveness. A balance shown on a statement is a pre-tax number, and comparing it with an after-tax brokerage balance is not a comparison.
Which assets belong in one: asset location.
Roth accounts
Taxed going in, never again. No tax on growth, no tax on withdrawal.
The mirror image of a tax-deferred account. You contribute after tax, so it costs more today, and then the government is finished with it. Growth is untaxed and qualified withdrawals are untaxed.
That makes it the most valuable account you own per dollar, and the value grows the longer you leave it alone, because the shelter applies to everything the money earns. It is the right home for whatever you expect to grow most.
It is also why spending it first in retirement is the expensive mistake. In our drawdown model, draining the Roth first costs 21.0% of everything you spend against 13.8% for the sensible order.
Why it goes last: which pocket you spend from.
Taxable brokerage
An ordinary investment account. Already-taxed money in, taxed every year on what it distributes, taxed again on gains at sale.
It sounds like the worst of the three and it is not, because of the rate. Long-term gains and qualified dividends get preferential treatment, and appreciation is not taxed at all until you choose to sell, which is a form of deferral you control.
The cost is the annual drag on whatever the account distributes whether you wanted it or not. A bond yielding 5% in a taxable account at a 24% marginal rate gives up 120 basis points a year before anything else happens.
No contribution limits and no withdrawal rules, which is why it is where money goes once the sheltered space is full, and why it is usually the right account to spend first.
The drag, quantified: two identical portfolios.
Health savings account
The only account taxed at no point: deductible going in, untaxed growth, untaxed for qualified medical spending.
Every other account gives you the break at one end or the other. An HSA gives it at both, provided the money eventually goes toward qualified medical expenses, which for most households it eventually does.
It also converts into something like a traditional IRA after a certain age, with withdrawals for anything else taxed as ordinary income rather than penalized. So the downside case is an ordinary retirement account and the upside case is tax-free.
Requires an eligible high-deductible health plan, and the contribution limits change annually. Look them up at the IRS for your year rather than trusting an article.
Where it sits among competing uses of a dollar: the order of operations.
Required minimum distributions
The age at which the government stops letting you defer and starts forcing withdrawals from tax-deferred accounts.
Deferral was always a loan, and this is the repayment schedule. From a certain age you must withdraw a minimum amount each year from tax-deferred accounts, calculated from the balance and your life expectancy, and it is ordinary income whether you needed the money or not.
The consequence for planning is that a very large untouched 401(k) is not an unambiguous win. It eventually becomes a large forced withdrawal at whatever rate applies then, potentially pushing you into a higher bracket than the one you deferred at. That is the argument for drawing some tax-deferred money earlier than a strict ordering would suggest.
Roth accounts are treated differently, which is part of what makes them valuable late.
Why it argues against a pure spending order: which pocket you spend from.
Roth conversion
Deliberately moving money from a tax-deferred account to a Roth, paying the tax now to escape it later.
You choose to realize ordinary income this year in exchange for never being taxed on that money again. It only makes sense if the rate you pay now is lower than the rate you would have paid later.
Which makes the timing everything. The years after you stop working and before required distributions and Social Security begin are usually the cheapest tax years of a lifetime: income is low, brackets are empty, and filling them deliberately is nearly free. Those are the conversion years.
It is the same idea as spending order, run in reverse. One decides which income to avoid realizing; the other decides when to realize it on purpose.
The window it exploits: which pocket you spend from.
DISCLAIMER ·
Education, not advice. Every example above is simplified to expose the mechanics. Real returns are volatile,
taxes and fees vary by country and account, and none of this considers your circumstances. 2 Comma Investor is not a
registered investment adviser or broker-dealer. Do your own research and consult a licensed professional before
acting.
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