We all have to pay taxes. While these dues are unavoidable, investing your money in tax-advantaged accounts can reduce your taxes. In addition, these tax benefits incentivize investors to stash money into assets that appreciate over time. You can select from various tax-advantaged accounts that each come with separate rules and criteria. We will discuss how these accounts work and explain some of the most popular tax-advantaged accounts.
What are Tax-Advantaged Accounts?
Tax-advantaged accounts let you invest in assets while saving money on taxes. Some tax-advantaged accounts lower your current bill, while others shield you from capital gains tax in the future. These accounts appeal to long-term investors who won’t touch their investments for years, or even decades, depending on how soon you invest.
How Do Tax-Advantaged Accounts Work?
Tax-advantaged accounts have maximum annual contributions. Most tax-advantaged accounts let you invest in stocks, bonds, and mutual funds. Some of these accounts provide more flexibility, letting you buy crypto and other alternative assets while saving on taxes.
Categories of Tax-Advantaged Accounts
Investors can select from various tax-advantaged accounts. While it can get confusing to navigate your choices, understanding the categories makes them simpler to understand. Each tax-advantaged account belongs to one of three categories.
Pre-Tax (Tax-deferred)
Tax-deferred accounts let you escape taxes now, but you’ll have to pay taxes after cashing out on distributions. Pre-tax contributions lower your taxable income, which also reduces your tax payment. For example, if you have $100,000 in taxable income but contribute $10,000 to a pre-tax retirement account, your taxable income drops to $90,000. This drop can save you thousands of dollars on your tax bill. Meanwhile, the $10,000 contribution will grow in your retirement account. Investors can select from the following tax-deferral accounts.
- Traditional 401(k) Plan: This tax-advantaged account is one of the most common accounts. Many companies offer 401(k) matching programs to help with retirement. You’ll have to wait until turning 59 and a half before withdrawing penalty-free money. You can withdraw before turning 59 and a half, but you’ll have to pay a 10% penalty plus taxes. You can continue holding money in your 401(k) after turning 59 and a half, but you must start withdrawing minimum distributions when you turn 72.
- 403(b) Plans: This tax-advantaged account is the nonprofit version of a 401(k) plan. You still have early withdrawal fees, contribution limits, and age requirements. If you work for a tax-exempt company, you’ll receive a 403(b) plan instead of a 401(k) plan.
- 457 Plans: Government employees receive these plans instead of 401(k) plans. These tax-deferral accounts are similar, but 457 Plans let you double your contributions three years before you reach the minimum age.
- Traditional IRA: This IRA has the same rules as a traditional 401(k) plan, but anyone can obtain this retirement account. You don’t have to work for an employer. Many business owners and self-employed workers use traditional IRAs to save up for retirement. They have lower contribution limits than the other plans.
After-Tax Investment
An after-tax investment account doesn’t help you escape taxes at the moment. Our previous example demonstrated how a tax-deferral account immediately lowers your tax bill. However, contributions to your after-tax account still count as taxable income. If you have $100,000 in taxable income and contribute $10,000 to one of these accounts, your taxable income still shows up as $100,000.
However, you won’t pay taxes on your way out; these accounts also protect you from capital gains taxes. If your investment triples in an after-tax account, you won’t owe capital gains on it. Dividend payouts can accumulate in this account without you having to worry about taxes. Some investors use their after-tax accounts to buy high-yielding dividend stocks because the yield is tax-free. Investors can select from the following after-tax investment accounts.
- Roth 401(k)/403(b)/457 Plans: These plans have similar dynamics as their non-Roth counterparts. The only difference is that these are after-tax investment accounts instead of the traditional tax-deferral accounts. They have the same requirements, but you also have to hold assets for at least five years before selling them to avoid early withdrawal fees. You still have to start taking out the minimum after turning 72.
- Roth IRA: This plan is the after-tax version of the traditional IRA. The same rules apply. A Roth IRA has a lower maximum contribution than a Roth 401(k) Plan. Some Roth IRAs let you invest in crypto.
- Roth Solo 401k: Self-employed business owners use these retirement accounts to pay taxes now and save later.
Other Tax-Advantaged Accounts
Most tax-advantaged accounts fall into pre-tax and after-tax categories, but a few accounts have unique properties.
- College/Education Savings Plans: Investors can choose from several college savings plans. These accounts let you save on college-related expenses, but some accounts allow you to withdraw funds to cover educational costs as early as kindergarten.
- 529 Plans: You can use these funds to cover any educational expense from kindergarten to college graduation. Most people with these plans are parents who plan to send their children to college. You won’t save taxes on these contributions, but they grow tax-free in your account. They are similar to Roth IRAs but for educational expenses. While college tuition is on top of most parent’s minds, you can use these plans for books, supplies, and other educational expenses.
- Coverdell Education Savings Account (ESA): This tax-deferral account lets you make tax-free withdrawals if you use the proceeds for qualifying educational expenses. You can only contribute $2,000 per child per year, but taxpayers with a modified adjusted gross income over $95,000 per year can’t create ESAs. Investors will face taxes and penalties on remaining funds that don’t get used before the child turns 30.
- Health Savings Accounts (HSAs): HSAs offer the most tax advantages. Contributions lower your taxable income, effectively reducing your tax bill, and you won’t have to pay any taxes when you take out distributions. You can use these funds to cover qualifying medical expenses. You can withdraw funds for any purpose without paying taxes after you turn 65. If you withdraw funds before turning 65 for a non-qualifying cost, you’ll owe capital gains and a 20% penalty fee.
How to Choose Which One is Best for You?
Selecting the best tax-advantaged account boils down to when you would like to pay taxes. A tax-deferred account lowers your tax bill at the moment, but you’ll owe taxes when you take out distributions. Unfortunately, some people wait until they retire to cash in on their tax-deferred accounts. Taking these funds out of your account when you make zero income will keep you in a lower tax bracket.
An after-tax account doesn’t help you escape taxes at the moment. However, you won’t pay capital gains on dividends or price appreciation. The IRS will stretch out its hand and ask for these gains if you take them out of a tax-deferred account. You can take out these funds once you hit 59 and a half years old without worrying about tax implications.
Invest in a Tax-Advantaged Account
A tax-advantaged account, or a retirement account, lets you save on taxes and grow your money in a tax-efficient way. Some investors contribute to multiple tax-advantaged accounts to capitalize on all of the benefits like a 401K at work as well as a Roth or Traditional IRA on their own.
