Every investor knows that regardless of how much money you make, the Tax Man will take his share. There’s simply no getting around taxes. There are, however, ways to either defer or reduce taxes. It’s only possible through tax-advantaged accounts. These are investment accounts that allow you to reduce taxes on your income. For example, a traditional IRA is tax-deferred, and a Roth IRA is tax-exempt.
There’s a smattering of different options when it comes to tthese accounts. Each comes with its own stipulations and criteria, and some are more accessible to investors than others. Here’s a rundown of what it means to invest through a tax-advantaged account and how some of the most common of these accounts work.
What Does “Tax-Advantaged” Mean?
First, a primer on what it means to have a “tax-advantaged” account. This is a broad term that applies to any type of account that reduces your tax burden. It can include:
- Tax-deferred recognizes an immediate tax deduction on the full amount invested; however, future withdrawals are subject to the ordinary income tax rate.
- Tax-exempt (Roth) allow after-tax contribution dollars to grow without the prospect of future taxes. Any amount withdrawn in the future is tax-free.
- Reduced-tax tends to include products and accounts exempt from state and local income taxes, yet subject to federal tax. Bonds are the best example of this.
The more of these investments a person has, the lower their overall tax burden. The lower the tax burden, the less taxes you owe. This is the fundamental principle for investing: keeping more of your wealth and allowing it to work for you. These accounts and other investments are the vehicles for this accumulation. The only question is: which vehicles are right for you?
Employer-Sponsored Retirement Accounts
A majority of investors grow their wealth through employer-sponsored retirement accounts. In addition, these accounts often come with many other perks that make them very appealing to workers. For example, a company may offer 401(k) matching up to a certain percentage of an employee’s annual salary.
Often, these accounts are funded with tax-deferred dollars. This allows employees to put away more of their income and contribute a higher principal balance. Here’s a look at the most common employer-sponsored tax-advantaged accounts:
- 401(k). This is the most popular retirement plan for private corporations. As of 2021, it has an annual contribution limit of $19,500. A 401(k) is also subject to minimum distributions.
- 403(b). A 403(b) is effectively the same type of account as a 401(k). However, it’s specific to non-profits and public education organizations. Another perk of these accounts is the ability to make catch-up contributions after age 50, pending certain qualifying criteria.
- 457(b). This plan has similar criteria to the 401(k) and 403(b) plans, but is specific to government workers. It has the same contribution limits as the other plans, with catch-up contributions available pending certain criteria.
Self-Administered Retirement Accounts
Not every employer offers retirement accounts—and not everyone works for someone else. Self-employed individuals or those without access to employer-sponsored plans have access to self-administered retirement accounts. These tax-advantaged vehicles offer many of the same benefits. Moreover, they allow investors to choose whether they prefer traditional contributions pre-tax or tax-exempt Roth contributions.
For example, here’s a look at some of the most common and accessible retirement accounts, and how they work:
- Traditional IRA. Anyone can open a traditional IRA through a brokerage or financial institution. This account is tax-deferred, meaning it’s funded with pre-tax dollars. As of 2021, traditional IRAs have an annual contribution limit of $6,000 ($7,000 for 50+).
- Roth IRA. A Roth IRA follows the same rules as a traditional IRA, only the money going in is already taxed—meaning it’s not taxed in the future when it’s withdrawn. Roth IRAs are generally the most popular form of self-administered tax-advantage account.
- Solo 401(k). If you’re self-employed or run a business where you’re the only full-time employee, a solo 401(k) is an option. It follows roughly the same rules as an employer-sponsored 401(k) with a few differences to better-accommodate entrepreneurs.
Other Types of Tax-Advantaged Accounts
In fact, retirement plans aren’t the only tax-advantaged accounts out there. There are also options for education and healthcare. And while these come with certain stipulations to guarantee their tax benefits, they’re nonetheless great vehicles for investors to capitalize on.
- Qualified Tuition Program (529 plan). Funds in these accounts grow tax free, and the IRS doesn’t tax distributions that cover education expenses.
- Coverdell Education Savings Account (ESA). This is a type of custodial account that allows parents to invest dollars in future education.
- Health Savings Accounts (HSAs). These are tax-advantaged accounts that allow the balance to accumulate tax-exempt, used for the purpose of covering medical expenses.
- Health Flexible Spending Account (FSA). Like an HAS, a flex spending account also offers certain tax advantages if the proceeds go toward medical expenses.
Always Consider Tax Benefits When Investing
Taxes are one of the biggest detriments to investors. Moreover, they’re liable to take a chunk out of your wealth. Thankfully, there are many types of tax-advantaged accounts out there that protect wealth by deferring, reducing or eliminating taxes. Choosing the best one comes down to what’s available, what you’re saving for and how you plan to invest.
Therefore, to learn how you can protect your investments and prepare for retirement, sign up for the Wealthy Retirement e-letter below. And in general, consider all of the above account options and make sure you’re speaking with a financial advisor to understand them in the context of your personal wealth and finances.