When you're planning for retirement, every dollar counts. Most experts recommend putting most of your money in tax-advantaged accounts like traditional individual retirement accounts (IRAs) or 401(k) accounts — an investment approach known as tax-efficient investing.

But the conventional approach might not be right for your retirement plan and financial goals.

What Is Tax-Efficient Investing?

A tax-efficient investment strategy involves reducing, deferring or better managing the taxes associated with investing. This approach can be complicated, but you can simplify your investment strategy to focus on tax-advantaged accounts.

What Are Tax-Advantaged Accounts?

Tax-advantaged accounts are investment or savings accounts that offer specific tax benefits, such as tax deferrals or tax deductions. You can invest in several tax-advantaged accounts.

Here's an overview of the most common options.

IRAs

You can save pretax dollars — the income you earn before federal and state taxes are deducted — in a traditional IRA. The money grows, tax-deferred, until you can begin taking withdrawals when you turn 59 1/2. If you withdraw money from your IRA before you hit 59 1/2, you'll face a 10% early withdrawal penalty in addition to standard income tax.

Depending on your income, you can fully or partially deduct contributions to a traditional IRA. For 2021, you can contribute up to $6,000 to a traditional IRA if you're under 50, and up to $7,000 if you're 50 or older.

But not all IRAs offer tax deductions. Though you can deduct contributions to a traditional IRA, a simple IRA or, if you're self-employed, a simplified employee pension IRA, you can't deduct contributions from a Roth IRA. Roth IRAs are funded by post-tax contributions. However, the benefit of a Roth IRA is that you can withdraw from the account tax-free at age 59 1/2.

401(k)s

Like an IRA, you can invest pretax income into a 401(k) plan and receive a tax deduction for your contributions. Unlike an IRA, there is no income limit for deducting your contributions. So even if you earn a high income, you could benefit from this tax deduction.

Most people have access to a 401(k) through their employer. But even if you have a 401(k), you can still open an IRA. This could be a good option if you have extra money to invest. However, many people prioritize saving in a 401(k), as employers often offer matching contributions — up to 5% of your salary, for example. If you earn $50,000 a year and contribute $2,500 to your 401(k) during the year, your employer will also contribute $2,500.

Another advantage of a 401(k) is its higher contribution limit. In 2021, you can contribute up to $19,500 to a 401(k) if you're under 50, and up to $26,000 if you're 50 or older.

Health Savings Accounts

A health savings account (HSA) lets you save pretax dollars for qualified medical expenses, such as insurance deductibles, co-pays and prescriptions. You can only qualify for an HSA, though, if you have a high-deductible health plan, which for 2021 is a health plan with a $3,500 deductible for an individual or $7,100 for a family.

HSAs offer a triple tax advantage: Contributions are made with pretax income; the money grows tax-free; withdrawals are tax-free if you use the money for qualified medical expenses. (You can use the money for other expenses, too, but you'll pay a 20% tax penalty.)

Some people consider an HSA as another retirement account, as you can withdraw money from an HSA penalty-free for any expense once you turn 65. You will have to pay income taxes on the money, though, if you don't use it for qualified medical expenses.

529 Plans

A 529 plan lets you save money for qualified education expenses — and is often passed down to children or grandchildren. These plans are administered at the state level, and many states cap deductions. For example, Massachusetts lets single filers claim a deduction of up to $1,000 and married filers can claim up to $2,000. The state's income tax rate is 5%, so single filers will save $50 on their tax returns and married filers will save $100.

The Advantages of Tax-Efficient Investing

Investing for retirement is inherently risky. There's no guarantee that your investments will accumulate value. However, one of the clearest benefits of tax-efficient investing is the tax deferrals and tax deductions.

In tax-deferred accounts, the money you invest isn't subject to taxes, so it could grow quickly over time, depending on how the stock market performs. You only pay taxes on your contributions and earnings or profits once you start withdrawing from the account when you turn 59 1/2.

Another advantage of tax-deferred accounts is that contributions yield either a federal tax deduction or a state tax deduction, which can mean tax savings when you file your tax return. Let's say you're in the 24% tax bracket and contribute the max to your 401(k), which, if you're over 50, is $26,000. This could reduce your taxable income by $6,240 (which is 24% of $26,000). If your taxable income was $56,240, you could reduce it and only have to pay taxes on $50,000. That could mean more tax savings or a bigger tax refund.

The Drawbacks of Tax-Efficient Investing

Tax deductions and deferrals are worthwhile benefits, but the trade-off is that you can't withdraw the money in an IRA or 401(k) until you're 59 1/2, and you can't withdraw funds from an HSA or 529 plan without incurring a penalty unless it's for qualified health care or education expenses.

These accounts are less flexible than traditional savings accounts and nontaxable brokerage accounts (what most investors use to buy and sell securities like stocks, bonds and mutual funds), which don't offer tax deductions on contributions. If you need money in an emergency, you can't easily access what's in your IRA, 401(k), HSA or 529 accounts without incurring penalties and taxes that could erase any gains you've made or even reduce the initial amount you invested.

Some people open brokerage accounts to let their money grow while maintaining the flexibility to access their contributions and earnings. The only downside is that you have to pay either short-term or long-term capital gains tax on any profit you make. However, if you hold on to stocks, bonds or other investment assets for at least a year, you can pay the long-term capital gains rate, which is usually lower than your income tax rate.

Considerations as You Plan and Invest for Retirement

So how should you design your investment strategy as you plan for retirement? It all depends on your goals and priorities and how much flexibility you need. If you plan to retire early or just want the certainty that you can access your money during tough times, then contributing to a diverse array of accounts might be the best approach. Investing in an IRA, a 401(k) and a brokerage account (or an HSA or a 529) could help you balance flexibility with growth potential and tax benefits — and that could put you in a better financial position when you're ready to retire.