ELI5: How Do Tax Advantaged Accounts Work?
Tax-advantaged accounts help you save money, grow your investment portfolio faster, and build wealth. However, they weren't all built the same. Knowing the difference can help you develop a smart tax strategy.
This article covers the primary types of tax-advantaged investment accounts investors will want to be familiar with and some of the ways you can use these accounts to save money come tax season.
The Short Version:
- Tax-advantaged investments are typically broken into two main categories: tax-deferred or tax-free.
- The two most common types of tax-advantaged investment accounts are 401ks and IRAs.
- Some special-use accounts, like HSAs or 529 plans, also provide tax benefits.
What Is a Tax-Advantaged Investment?
Tax-advantaged investments offer some sort of tax benefit. This can be tax exemption, the ability to defer paying taxes on income, or the ability to grow an investment completely tax-free.
These types of accounts can range from savings plans to investments made through a brokerage firm.
The most common type of tax-advantaged account people have access to is a retirement account sponsored by their employer. This is typically a 401(k) or similar retirement plan. It can also include savings plans like a health savings account – or HSA. Other types of tax-advantaged accounts include individual retirement accounts set up through a brokerage or a 529 college savings plan.
Types of Tax-Advantaged Accounts
There are different types of tax-advantaged investments you can use depending on your financial goals and overall tax strategy. Some accounts provide a tax shelter for your investments while others allow you to reduce your taxable income in a given year.
Tax-deferred accounts can help you lower your taxable income. Instead of paying taxes on your contribution now, you pay them later, upon withdrawal — for most people, that’s retirement.
The most common type of tax-deferred accounts are traditional IRAs and 401(k)s. The money deposited into your 401(k) uses pre-tax dollars, so the money is pulled straight from your paycheck before it is taxed.
For employer-sponsored accounts, your contribution is part of your work compensation package. Employers will typically make a contribution on your behalf. This is referred to as your employer match. It is basically free money that you can use to build your retirement portfolio.
However, not all employers offer tax-deferred retirement plans. If a worker isn’t covered by one, contributions to a traditional IRA may also be tax deductible. Anyone can open up an individual retirement account with a brokerage firm and make contributions on their own.
In 2023, workers are allowed to contribute up to $22,500 to their 401(k), 403(b), and most 457 plans. IRAs are capped at $6,500.
Contributions made to tax-deferred accounts reduce the amount of income reported to the IRS, which lowers a contributor’s overall taxes. For example, someone who earns $100,000 and makes a $20,000 contribution to their 401(k) will pay taxes as if they only earned $80,000. Depending on your income level, investing more in a tax-deferred account can move you into a lower tax bracket, resulting in further savings.
While tax-deferred accounts can help reduce your taxable income in the short term, when you retire, your 401(k) distribution is taxed as regular income. These withdrawals will raise your overall taxes for that year.
Learn more about tax-deferred accounts >>>
Tax-exempt accounts can help your investments grow tax-free. Contributions to these accounts are funded with after-tax dollars meaning you’ve already paid taxes on them.
As a result, you won’t have to pay taxes on income generated in these accounts, nor on the appreciation of your principal investment.
The most popular tax-exempt accounts are Roth IRAs and Roth 401(k)s. Non-retirement tax-exempt accounts include 529 savings plans, which can be used for educational expenses.
Because you’ve already paid taxes on your contributions, any money withdrawn from a tax-exempt account will not be taxed. This can help you reduce your tax burden in the future.
However, there are limitations to how much money you can contribute in a given year. IRAs are capped at $6,500 (or $7,000 if you’re older than 50). Other tax-exempt accounts, like 529 savings plans, also have rules specific to the state they are in.
Related >>> Roth IRA Rules and Contribution Limits 2023
How Do You Choose Which To Invest In?
The type of account you invest in will largely depend on your income.
A low-income earner may not benefit from trying to reduce their taxable income in the short term, especially if it doesn’t change which tax bracket they are in. However, if they have access to an employer-sponsored 401(k) they can still benefit from earning their employer’s match. Beyond that, a tax-deferred account probably won’t lead to a lot of tax savings.
Low-income earners, however, can benefit from investing in a tax-exempt account. Contributions to these accounts are made at their current tax rate. When they retire they will have already paid taxes on money contributed to a tax-exempt account. This means if their income increases over the course of their career and they move into a higher tax bracket they won’t have to pay taxes at a higher rate. With these accounts, they pay now and withdraw tax-free later.
High-income earners, on the other hand, may want to consider contributing to a tax-deferred account such as their employer-sponsored 401(k). This can reduce their taxable income in the short term and move them into a lower tax bracket. This can lead to cost savings that can in turn be redeployed into a different investment account.
Health Savings Accounts (HSA)
One tax-exempt account that has extra benefits is an HSA or health savings account. These accounts allow you to contribute pre-tax dollars, reducing your short-term taxable income. At the same time, they allow you to grow your contribution tax-free, like a Roth IRA. Qualified withdrawals used for medical purposes are also tax-free. For these reasons, HSAs are considered a “triple benefit” account.
Investors with access to an HSA should consider investing in it regardless of income level. This type of account allows you to grow an investment tax-free for medical expenses. Whether you use the funds now or later, withdrawals made from an HSA are also tax-free. It's likely that a significant portion of your expenses in retirement will go towards medical expenses anyways. So getting started investing in an HSA sooner rather than later can be a smart investment choice.
Other Ways To Reduce Taxes on Your Investments
There are other strategies investors can use to earn tax savings. Some of these strategies can reduce your tax burden even further while others can allow you to grow an investment portfolio completely tax-free.
Roth Conversion Ladder
A Roth Conversion Ladder is a tax strategy that early retirees often use. This is a process that takes a few years to put into action but it can reduce early withdrawal tax penalties, saving money in the long term.
Investors first roll over a 401(k) into a traditional IRA. From there, the traditional IRA is converted to a Roth IRA. Investors who do this are taxed on the conversion but they can avoid the 10% penalty for withdrawing contributions before age 59 ½.
Learn more about how it works >>> Roth IRA Conversion Ladder: Ultimate Tax Hack for Early Retirees?
Self-Directed Individual Retirement Account (SDIRA)
A self-directed individual retirement account is an investment account that can hold assets a typical IRA cannot. This can include private stock, real estate, precious metals, and even cryptocurrencies. An SDIRA is managed by financial institutions on behalf of the investor.
There are limitations on what type of assets can be held in an SDIRA. An SDIRA can hold real estate, for example, but not a valuable baseball card. The IRS tries to mitigate fraud by imposing rules for each type of asset allowed in an SDIRA. Breaking those rules can incur extra taxes and penalties. Maintaining an SDIRA account also tends to come with more fees than a traditional IRA or a Roth IRA.
The Takeaway: Which Tax-Advantaged Account Is Right for You?
The best way to figure out which tax-advantaged account is right for you is to consider your financial goals. If you want to reduce your taxable income this year, consider investing in a tax-deferred account. If you don’t make a lot of money right now but want to benefit from future tax-free income, a tax-exempt account might be a better option.
You should also consider your future expenses. HSAs and 529 savings plans are tax-exempt accounts designated for specific purposes. If you plan on sending kids to college someday and expect to incur new medical expenses as you get older, a specific tax-advantaged account might offer greater benefits than a standard 401(k).
Regardless of which you choose, all tax-advantaged accounts are hugely valuable tools to help you build long-term wealth.
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