from Guide to Adulting on Oct 15, 2023

How retirement savings work

The first week of any job is filled with a number of confusing decisions. Among those is what to do with a "401(k)". In this post, we'll discuss what that is, along with retirement savings strategies in general.

Below, we're share several "stages" of retirement savings. Think of these as increasing levels of aggressiveness in your retirement savings strategy. At a bare minimum, you should complete the first stage, because the financial advantages are clearest and simplest in that case. In each subsequent stage, you're making more and more nuanced bets, with additional considerations.

Stage 1. Contribute pre-tax to a 401(k).

When you first start a new job, you have an option to enroll in the company's 401(k)1 — a retirement savings account. This account has a few special properties that make it financially advantageous:

  1. Pro: Contributions are made pre-tax. Any money you set aside in a paycheck to deposit into a 401(k) are made "pre-tax". This means the money you deposit is (a) not taxed and (b) deducted from your total taxable income. In this way, you save taxes in the near-term.
  2. Pro: Some employers match contributions. This means that for every dollar you contribute to your 401(k), your employer will also contribute a dollar. This is usually up to a certain percentage of your salary and up to a certain dollar amount.

There are a number of caveats; we detail three key ones below:

  1. ⚠️ Limits: There are limits to how many of these pre-tax dollars you can contribute, per year: As of 2023, this limit is $22,500 if you're under 50 and $30,000 otherwise2. You and your employer can together contribute no more than $66,000.
  2. ⚠️ Excess contributions: If you contribute too much, possibly due to a job change or multiple jobs, you may contribute beyond this limit. These excess contributions need to be withdrawn and reported according to the IRS's "Consequences to a participant who makes excess deferrals to a 401(k) plan".
  3. Rollover: Once you leave your job, you must then convert this 401(k) into a "Rollover Individual Retirement Account" — in other words, a retirement savings account that you now own, independently of your former employer. We'll talk about this later.

This is the first step in saving for retirement, where you contribute pre-tax dollars to an employer-managed retirement savings account.

Stage 2. Contribute post-tax to a 401(k)

For a 401(k) at some companies, there are two different retirement savings options to choose from, each with their own way of saving you taxes.

The deciding factor is when you pay taxes: Do you want to pay taxes when depositing into or when withdrawing from your retirement savings?

  1. Pay taxes when withdrawing from retirement savings.

    1. Pro: Pay taxes at a lower percentage. This could be advantageous, as your tax rate as a retiree — when you withdraw — is likely lower than your tax rate now — when you deposit. In short, the percentage paid in taxes would be lower, by paying taxes later at your retirement tax bracket.
    2. Con: You pay taxes on growth. Your retirement savings can grow in value over time. You will owe taxes on these earnings when you withdraw during retirement. This means your account grows tax-deferred.
    3. Pro: You can claim tax deductions. If your income does not exceed a certain amount, you can claim tax deductions to lower your taxable income for the year. If you qualify for these deductions, this means you're contributing pre-tax dollars into your retirement savings.
    4. Pick a Traditional retirement savings account, if this option sounds appealing. You would pick this option if you believe (a) your tax rate as a retiree would be lower than your tax rate now and you qualify for tax deductions or (b) your retirement savings won't grow appreciably by then. The first case is likely true if you're working full-time at your first job. The last case could be true if you're within a few years of retirement.
  2. Pay taxes when depositing into retirement savings. Deposits are formally called "contributions".

    1. Pro: Pay taxes on a smaller total. This could also be advantageous, as the amount you contribute now could grow in value over time and be ultimately less than the amount you withdraw. In short, the total taxable amount would be lower, by paying taxes now on the amount you contribute.
    2. Pro: You don't pay taxes on growth. Your retirement savings can grow in value completely tax-free.
    3. Con: You pay taxes now. Echoing the points above, the money you contribute is considered post-tax dollars, meaning you still pay income tax on that amount.
    4. Pick a Roth retirement savings account, if this option sounds appealing. You would pick this option if you believe (a) your tax rate now is similar to or lower than your tax rate as a retiree or (b) your retirement savings have significant amounts of time to grow appreciably. This may be you if you're doing an internship or working a part-time job, especially true if you're an undergraduate or early in your career, in either of those positions.

Here's a tabular summary of the above key takeaways, for picking a Traditional (pay later) or Roth (pay right now) 401(k).

Traditional Roth
Pay taxes when withdrawing depositing
Savings grow tax-deferred tax-free
Pay taxes at a lower rate on a smaller amount
Tax rate now is higher than in retirement is same or lower than in retirement
Retirement savings will not grow a lot will grow a lot

We've now covered the basics for maximizing employer-provided retirement savings accounts. Let's now discuss options outside of employment.

Stage 3. Contribute post-tax to an IRA

Independently of your employer, you can also create and contribute to an Individual Retirement Account (IRA). Just like with a 401(k), there exists both Traditional and Roth IRA account types. However, certain tax benefits are available to you only at certain income levels. For example, as of 2023, if you're filing "single":

This gives us three categories of possibilities, based on your employer's coverage and income levels. For simplicity, I'll only cover the "single" scenario below; if you're filing as a married couple, you can see Fidelity's "Which IRA is right for you?" page for details, both for the above scenarios and for married couples.

  1. Case 1 — You don't qualify for a Roth IRA or Traditional IRA tax deductions: This is you if you're single, covered by your employer, and your income exceeds $153,000. Your only option is to pay taxes now and contribute post-tax dollars to a Traditional IRA. Your contributions grow tax-deferred, meaning you still pay taxes on earnings at withdrawal. There's no choice to made here.

    1. There is a option called a Backdoor Roth IRA, where you roll over funds from a Traditional IRA to a Roth IRA, or simply convert your entire Traditional IRA into a Roth IRA. Since you paid taxes on your contributions already, you owe taxes only on the Traditional IRA's extra earnings. From that point onwards, the Roth IRA's earnings are tax-free. This is likewise — technically — a no-brainer.
    2. Note that this is my own opinion, not professional advice. See the Fidelity page above for more details. For example, if you're within 5 years of retirement, the Roth IRA's 5-year rule may affect your decision.
  2. Case 2 — You qualify for a Roth IRA but not for Traditional IRA tax deductions: This is you if you're single and your income is no more than $153,000. As a result, regardless of which IRA you pick, you pay taxes now. The key remaining difference is that a Roth IRA allows contributions to grow tax-free, whereas earnings from a Traditional IRA are ultimately taxed at withdrawal. If you're in this camp, pick a Roth IRA as its earnings are tax-free. There's technically no choice to be made here.

  3. Case 3 — You qualify for both a Roth IRA and for Traditional IRA tax deductions. This is you if you're either (a) not covered by an employer-sponsored retirement savings account or (b) you are, but your income is no more than $83,000. The pros and cons we outlined in the previous section apply to you in this case, and you have both options available to you.

Just like with 401(k)s, there are contribution limits — $6,000 for those under age 50 and $7,500 otherwise, as of 2023 per Fidelity's "IRA contribution limits" page — and if you make excess contributions, you must take action to avoid penalties.


To summarize, we've discussed three strategies, with increasing levels of aggressiveness in retirement savings planning. The below are the recommendations I've gathered from different resources:

  1. In the first level, make pre-tax contributions to a Traditional 401(k).
  2. In the second level, consider making post-tax contributions to a Roth 401(k), if one is available.
  3. In the third level, make post-tax contributions to an IRA. At a high level and informally, Roth IRAs are the ultimate goal.

    1. If you don't qualify for a Roth IRA, setup a backdoor Roth IRA.
    2. If you do qualify for a Roth IRA but not for tax deductions, contribute to a Roth IRA.
    3. If you additionally qualify for tax deductions, then you'll need to weigh pros and cons of a Traditional vs. Roth IRA.

Now that you have an understanding of the basics, see the following for more information, caveats, and opinions and experts on the topic.

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  1. The 401(k) we discuss above is offered by for-profit entities. There are other types of employer-sponsored retirement savings accounts as well, such as a 403(b) is offered by public schools and 501(c) organizations (IRC 403(b) Tax-Sheltered Annuity Plans). You can find a full list of different retirement plans on the IRS "Types of Retirement Plans" webpage. 

  2. According to the IRS "Retirement Topics - 401(k)… Contribution Limits", contributions to a 401(k) are limited to $22,500 in 2023. The webpage refers to this money as an "employee elective deferral," which is where an employee accepts payment as a 401(k) contribution in lieu of salary.