Milestone 5: Save 15%-25% in Tax-Advantaged Retirement Accounts
If you’ve reached Milestone Five on the Next Dollar Roadmap, then you’ve come a long way.
You now have plenty of cash to absorb out the financial impact of a significant expense or hit to your income.
Your debts, if any, should be on appreciating assets and have low interest rates.
Finally, you’re enjoying the benefits of your employer’s matching dollars by contributing to your employer-sponsored retirement plan or Health Savings Account.
- Starting Point: Creating Your First Budget
- Milestone 1: The Uh-Oh Fund
- Milestone 2: Take Advantage of Your Employer Match
- Milestone 3: Pay Off Toxic Debt
- Milestone 4: Fully Funded Emergency Fund
- Milestone 5: Save 15%-25% of Your Income in Tax-Advantaged Retirement Accounts
- Milestone 6: Save for Flexibility in Bridge Accounts
- Milestone 7: Prefund Kids’ Expenses
- Milestone 8: Pay Off Remaining Debt
- Milestone 9: Total Financial Independence
Milestone five is saving 15%-25% of your income in tax-advantaged savings vehicles.
Some of this will be a repeat of information we passed along from Milestone 2, but we want to get all of the relevant information for Milestone 5 in the same post.
You want to take advantage of tax-advantaged accounts because the potential savings over time can be enormous.
Let’s jump right into an example so you can see what we’re talking about.
Joe Dollar
Joe Dollar has completed Milestones 1 thru 4, including his company’s 6% match, and still has money left over to invest somewhere else.
Currently, he’s debating whether or not to contribute more money to his 401(k) or to open a taxable brokerage account and invest the money there.
Joe’s salary is an even $100,000. So, in 2025 this means Joe is already putting $6,000 of the maximum $23,500 the IRS allows into his 401(k).
Let’s look at the financial implications of directing an additional $17,500 into the 401(k) versus investing it in a taxable brokerage account.
We will assume Joe is in the 22% income tax bracket, the 15% long-term capital gains bracket, and that he will be in the same tax brackets no matter when he withdraws the money.
We will also only track the value of the $17,500 he contributes beyond his employer match since this is the amount in question.
Finally, we will assume an annual return of 10% on Joe’s investment for both possibilities and that he will withdraw both the contributions and earnings in 20 years.
As we evaluate Joe’s options, remember that the principal joe places into his account will ultimately be taxable as income either way.
If he accepts the income and then places it into the taxable brokerage, he will pay income tax on the $17,500 now.
If he puts it in the 401(k) the $17,500 will be taxed when he withdraws it in retirement.
This would be true for a Roth 401(k) contribution too, but we won’t be using the Roth as an example because it doesn’t really change the ultimate point. Besides, the end result is the same for Roth or Traditional when income tax rates and interest rates remain constant (more to come on this).
As a result, the only values that matter in this analysis are the gains or growth of the assets above $17,500 over time.
Joe’s 401(k) Option:
Assuming Joe puts the additional $17,500 into his 401(k) none of the money is taxed going in, so he receives the full benefit of investing $17,500.
In 20 years, Joe will have $117,731.25 before taxes. After paying 22% income tax on the withdrawal, Joe’s $17,500 has turned into $91,830.37.
Joe’s Taxable Investment Option:
In this scenario, the $17,500 principal Joe could have put into his 401(k) is now worth $13,650.00 after he has paid income tax.
In 20 years, this amount grows to $91,830.37 before taxes. Once Joe pays a 15% long-term capital gains tax on the growth beyond his initial deposit [($91,830.37-$13,650.00) x 0.15 = $11,727.06 in gains tax] he has a total of $80,103.32.
In summary, forgoing the option of using his tax-advantaged 401(k) would cost Joe an additional $11,727.06 in capital gains tax when he withdraws the funds in 20 years.
Put another way, assuming everything else stays the same, the cost of going the taxable route is equal to the applicable long-term capital gains rate.
Currently, long-term capital gains tax rates are 0%, 15%, or 20% depending on your income tax bracket. (Note: Long-term capital gains apply to assets owned for at least one calendar year. Short-term gains are taxed at your normal income tax rate.)
The 401(k) is just one example of several tax-advantaged options available to Americans in order to encourage saving for retirement. Let’s walk through some other popular plans and share some of the details of each.
401(k)s/457s/403(b)s
Let’s start by discussing 401(k)s, 457s, 403(b)s, and Solo 401(k)s.
All of these account types are available through an employer-sponsored retirement plan where you work. In the case of the Solo 401(k), you are acting both as the employee and the employer which provides a unique opportunity that I’ll touch on in a minute.
Traditionally, contributions to these plans are made on a tax-deferred basis meaning the money is placed into your account via payroll deduction before any taxes are withheld.
The contributions can be invested, and any earnings can grow without any tax implications until you make withdrawals in retirement. Those withdrawals are all subject to normal income taxes.
All of these account types also allow for Roth contributions which are subject to income tax, but all subsequent earnings and withdrawals are completely tax free. I’ll touch on this more later.
About 86% of the time, employers will also make some sort of matching contribution on behalf of their employees. The average matching rate in the United States is just over 4%.
The maximum annual contribution to a 401(k) in 2025 is $23,500 if you’re under 50, $31,000 if you’re between 50 and 59 or over 64, or $34,750 if you’re between 60 and 63. (The multiple catch-up provisions are new in 2025.)
Additionally, many plans allow participants to make after-tax contributions up to $70,000 per year (plus the applicable $7,500 or $11,250 catch-up provisions depending on your age). This ability is plan-specific, so you’ll need to check with your employer to see if it’s available to you.
If you make withdrawals from these accounts before age 59.5, you’ll owe a 10% early withdrawal penalty. The notable exceptions are 457 plans which can be tapped upon retirement at any age, and access to 401(k) or 403(b) plans using the Rule of 55.
We have other videos about these plans’ early withdrawal options which I’ll link below.
Individual Retirement Accounts (IRAs)
IRAs have been around since the late 1970s when there was a major shift in American retirement planning away from the traditional defined benefit pension.
You do have to have earned income in order to contribute to an IRA (or have a spouse with earned income), but those contributions can be made on either a Roth or Traditional basis.
You can open an IRA at almost any brokerage or investment company like Fidelity, Vanguard, Schwab, etc.
The contribution limits for 2025 are $7,000 if under 50 or $8,000 if you are 50 or older.
Similar to most employer-sponsored retirement plans, you have to wait until age 59.5 to make penalty-free withdrawals from an IRA (and once again, there are some exceptions), but contributions made on a Roth basis are always available for withdrawal.
There are several hacks and nuances to IRAs that I won’t get into in this post, but if you want to read more just look at topics like The Five-Year Rule, Roth Conversions, and The Backdoor Roth IRA.
Health Savings Accounts (HSAs)
Health Savings Accounts are unique in several ways, not the least of which is their ability to provide a tax break on contributions, earnings, and withdrawals.
HSAs are the only tax-advantaged account that gives you this triple tax benefit providing the potential for completely tax-free transactions.
In your face, Ben Franklin.
Additionally, if you make contributions to an HSA through payroll deductions at work, you’ll save another 6.2% in Social Security taxes and 1.45% in Medicare taxes (7.65% total).
This is why HSAs can potentially provide a greater tax benefit than any other account type discussed in this post.
It is important to note that you can only make contributions to an HSA while you are also enrolled in a High-Deductible Health Plan (HDHP).
The eligible minimum deductible for HDHPs changes from year to year.
In 2025 the minimum deductible is $1,650 for individuals and $3,300 for families.
The maximum annual contribution in 2025 for individuals is $4,300 and $8,550 for families. There is also a $1,000 catchup provision for those who are 55 or older.
Until you reach age 65, there is a 20% withdrawal penalty for withdrawing funds from an HSA that aren’t used for a qualified medical expense. (For a list of qualified medical expenses, see IRS Publication 502.)
One excellent feature of HSAs is that once you turn 65, you can withdraw money from your account for any reason, without penalty. However, you will still owe income taxes on distributions that aren’t used for qualified medical expenses.
This feature is particularly useful when you consider that HSAs are one of the least tax-friendly ways to leave an inheritance to your heirs because the full balance of the account has to be distributed and taxed in the year it is inherited.
The notable exception is spouses who can continue to use the HSA as if it is their own.
If you can, you and your spouse should liquidate your HSA in your lifetimes if at all possible. If you’re charitably minded, you could also leave your HAS to a tax-exempt charity since they won’t be subject to income taxes on the distribution.
That was quite a bit of information, so here’s a table that consolidates much of the information above.
Roth vs Traditional Contributions
With the exception of HSAs, all of the tax-advantaged retirement accounts we’ve covered potentially accept contributions on a Roth or Traditional basis.
One common point of confusion is that a “Roth account” is an account type, which isn’t technically true. The word “Roth” refers to the tax-treatment of the account only.
In the case of a Roth, taxes are collected before contributions are made, but earnings and withdrawals are all tax free.
Tax-deferred or “Traditional” accounts allow you to make contributions before taxes are withheld (if made at work) or provide the opportunity to take a tax deduction (if made in a plan outside of work).
So, any “Roth” or “Traditional” account you have is actually a 401(k), 457, 403(b), IRA, etc. account that receives either Roth or Traditional tax treatment.
Regarding Those Taxes…
Before I explain which tax treatment is best, let me illustrate an important mathematical principle.
If the tax rate and rate of return are equal, then there is no advantage to Roth over Traditional or vice versa.
For example, let’s assume you have $1,000 you want to direct into an IRA, you are in the 12% tax bracket, and you expect the realized rate of return for your investment to be 10%.
Making a tax-deferred or Traditional contribution, you won’t pay tax upfront so you get to put $1,000 into the account which earns $100 at 10%, leaving you with $1,100 pretax dollars. After you pay $132 in taxes (12% of $1,100), you’ll have $968.
Assuming you instead make contributions on a Roth basis, you’ll have $880 available after taxes to contribute to your account (12% of $1,000 is $120). A 10% return on $880 is $88, leaving you with an after-tax total of $968.
Like I said, same tax rate, same rate of return, same result.
Since we can’t predict rates of return and you shouldn’t adjust your overall asset allocation just because you’re making Roth or Traditional contributions, the factor that really matters here most is your tax rate.
Now, the nice thing about having Roth or Traditional options is if your tax rate is different when you make contributions and withdrawals, you effectively get to pick when you pay your taxes.
Naturally, you want to pay taxes when you’re in the lower tax bracket.
So, if think your income is lower when you make contributions than when you’ll make withdrawals, you should use Roth. For many young investors with lower incomes, this is the way to go.
However, if you have high income and think you will be in a lower tax bracket in retirement, then Traditional or tax-deferred is the way to go.
There are more things to consider here, but I don’t want to belabor the point right now. For a lengthy explanation of the options please read my post about choosing a Roth vs Traditional IRA or 401(k) or check out our YouTube video covering the same topic.
How to Prioritize Contributions
Another item to bear in mind is that you will probably have access to more than one of the tax-advantaged accounts we’ve discussed.
In fact, only 401(k)s and 403(b)s are exclusive of one another meaning you get the same annual limit to share across both accounts if you happen to have access to them. (There is a notable exception to Solo 401(k)s, but you’ll have to visit my Solo 401(k) post to read more.)
With access to such a variety of accounts, each with its own rules and limitations, there is certainly an order of priority that will yield the best financial outcome for you.
Here are my general rankings of these accounts, followed by a brief justification for each one. Please note that this is a general listing and the actual “best” order will depend on your personal circumstances. For more information, you can read this post about prioritizing these accounts.
- HSAs w/ Employer Match – Triple tax-advantaged plus free money from the boss makes this a no-brainer.
- Employer Plan w/ Employer Match – Tax advantages with free money. Was #1 before HSAs came along.
- 457 Plans – 457s are very similar to 401(k)s and 403(b)s but offer the flexibility of penalty-free withdrawals upon retirement, at any age. This flexibility puts them ahead of other “400” level accounts.
- IRAs – IRAs come in ahead of other employer sponsored plans because they give you complete control over your investment options where employer sponsored plans may introduce undesirable limitations.
- 401(k)s and 403(b)s – Don’t sleep on the benefits of these accounts just because we’re all the way down at #5. Most millionaires clear the 7-figure threshold thanks in large part to their 401(k) or 403(b). Odds are, you’ll need this option anyway as the higher ranked account types are somewhat limited by contribution maximums or matching contribution caps.
- Taxable Accounts – No, there aren’t really “tax-advantaged”, but I’m listing them anyway in case you run out of space in the account types above. Long-term capital gains taxes available through these accounts are still preferable to income taxes making them a solid option.
Options one through five above all have a maximum contribution limit, but you only need to contribute up to a portion of that amount unless you’re just rolling in cash without any other place to put it.
I recommend saving 15% to 25% of your income in these accounts in the order listed above.
Why 15% to 25%?
In full disclosure, when I first started this website and began suggesting that people save and invest at least 15% of their income, I did so because that’s the goal my wife and I had always set for ourselves and it has worked out pretty well.
However, my wife and I started saving and investing when I was 25 and she was 23. Not everyone has the opportunity to get started that early and as a result, they don’t have as much time to enjoy the benefits of compounding interest.
The fact is the amount of time you have to invest is a major factor in how large your nest egg will grow.
If you can’t get started early in your career, then you’ll need to play a bit of catch-up later.
In an effort to figure out just how much one would need to contribute in order to retire with a portfolio capable of reproducing 80% of their pre-retirement income, I did some math and wrote a post about it.
The basic goal was to find suggested savings rates as a percentage of income based on the number of years you were from retirement and an expected rate of return.
Having this information allows you to see how much you need to save now to retire any number of years into the future.
The table gives you the flexibility to evaluate all of your options.
So, based on this information, if you were able to save 25% of your income for 20 years and achieved an average annual return of 12%, you could retire with a portfolio that replaces 80% of your pre-retirement income.
Also, saving just 15% of your income for 37 years at a modest 6% return would produce the same result.
Naturally, some people start early and some start late, but everyone needs some idea of how much to save in order to retire. The table provides that information.
And, since making a title for Milestone 5 forced me to provide a hyper-condensed summary of the table that communicates the same information at a general level, 15% to 25% is the range I’ve provided.
More specifically, if you start saving and investing in your 20s you will probably do just fine setting aside 15% of your income to that end. If you start in your 30s, I would bump the savings rate up to 20% and if you start in your 40s or later, better make it 25% or more.
If you are blessed with the ability to save even more, I’ll explain why you may or may not want to do that in Milestone 6: Invest for Flexibility.
