Tax-advantaged accounts are one of the best tools for retirement that exist.
No one likes to pay taxes, and when it comes to saving and investing for retirement, they can be one of your biggest expenses. Of course, you should try to minimize your taxes if you can!
Let’s look at someone who didn’t use tax-advantaged accounts as an example.
If that person invested $10,000 in a brokerage account and lets it grow for 40 years with a +7% return, the investment would grow to just under $150,000.
Actually, $149,745 to be exact.
However, all of that money would truly be theirs! There would be a 15% capital gains tax owed to Uncle Sam. Subtracting that from the initial investment, $20,962 would be owed on the $139,745 of growth.
In reality, the investment is only worth about $130,000, not $150,000.
That’s a huge hit because of taxes, and is one issue that tax-advantaged accounts can help solve.
What are Tax-Advantaged Accounts?
A tax-advantaged account is exactly what it sounds like, an investment account that provides a tax benefit.
Specifically, it provides either a tax-exempt or tax-deferred benefit.
- Tax-deferred accounts: Otherwise known as pre-tax accounts, these accounts allow you to deduct contributions from your current year income. You’ll pay less on taxes now, but still pay taxes in retirement. Examples of this type of account include Traditional 401(k)s and Traditional IRAs.
- Tax-exempt accounts: Otherwise known as after-tax accounts, these accounts provide a future benefit, You’ll pay taxes now on your income, but the money will grow tax-free and you won’t owe taxes when you make withdrawals in retirement. Examples of this type of account include Roth 401(k)s and Roth IRAs.
Tax-Advantaged Accounts: An investment account that provides a tax benefit either upon deposit or withdrawal.
If the definitions of these types of accounts are not immediately clear, don’t worry, we’ll provide more detail further below when highlighting the four main types of tax-advantaged accounts.
The Benefit of Tax-Advantaged Accounts
The benefit of a tax-advantaged account is that you get to keep more of your money in retirement. Pretty straight forward.
The Benefit of a Tax-Exempt Account
Going back to the example we used earlier, what if the initial $10,000 had been invested in a tax-exempt Roth IRA account instead of a taxable brokerage account. Well, 40 years at a +7% return, the money would still grow to about $150,000, but there wouldn’t be any taxes owed.
That’s right, you wouldn’t own $20,000 in taxes, you’d owe nothing (assuming you wait until retirement age to withdraw the funds).
The $150,000 would be worth $150,000.
The Benefit of a Tax-Deferred Account
Using the same example, if the initial investment had been made in a tax-deferred account like a traditional IRA, you’d actually have more money to contribute upfront since you’d be paying fewer taxes on your income.
In this example, let’s assume you make $50,000 annually and that your current income tax rate is about 20%.
Round numbers make things easy.
Instead of paying $10,000 in taxes on your $50,000 income, since you are contributing $10,000 to a tax-deferred account, you’d only pay $8,000 in taxes on $40,000 of taxable income.
You could in theory invest the extra $2,000 you receive in tax savings, bringing your initial investment to $12,000.
This $12,000 would grow to about $179,000 over the 40 year time period. You’d still have to pay capital gains taxes on your investment, but would be left with about $154,000 after it was all said and done!
The $179,000 would be worth $154,000.
The examples and math above are very high level, but should provide a really clear picture of the monetary benefit of tax-advantaged accounts. Whether using a pre-tax or after-tax account, you are left with more money than a brokerage account when you reach retirement, all else equal.
The flip side of this benefit is that these types of accounts usually come with restrictions. There is a limit on how much money you can contribute, when you can access your money, and more. We’ll get into those details below.
Four Major Types of Tax-Advantaged Accounts
There are four major types of tax-advantaged retirement accounts that fit within the tax-deferred (pre-tax) and tax-exempt (after-tax) buckets outlined above.
1. Individual Retirement Accounts
First on the list are individual retirement accounts, or IRAs for short.
Note: The IRS may refer to IRAs as individual retirement arrangements.
There are two different types of IRAs, a Traditional IRA and a Roth IRA.
A Traditional IRA is a pre-tax account that allows you to take an income tax deduction in the year contributions were made, lowering your tax bill. However, you then pay ordinary income tax on your withdrawals in retirement.
A Roth IRA is an after-tax account in which you contribute after-tax income that will grow tax-free. Come retirement, you won’t have to pay any taxes on your withdrawals.
Both types of individual retirement accounts have a similar set of rules:
- Max Contributions: In 2021, the maximum amount of money you can contribute to either type of IRA is $6,000 annually ($7,000 if you are 50+ using catch-up contributions).
- Withdrawal Rules: Money withdrawn before age 59.5 has a 10% early withdrawal penalty. The one exception is that you can withdraw your contributions to a Roth IRA (not capital gains) at any time penalty-free.
- Mandatory Withdrawals: In regard to Traditional IRAs, you must start withdrawing from the plan at age 72 to avoid penalties (if you were born after June 30, 1949). This is also known as your required minimum distributions (RMDs).
- Income Limits (Roth): Your ability to contribute to a Roth IRA reduces (and eventually goes down to $0) if your modified adjusted gross income (MAGI) is above certain levels. If you are single or filing separately from your spouse the limit is $125,000. If you are married filing jointly the limit is $198,000.
- Income Limits (Traditional): For a traditional IRA, the limits depend on if you qualify for a retirement plan through work. If you do not qualify for a corporate-sponsored plan, then there are no income limits.
Keep in mind, the $6,000 limit applies to both types of IRAs. You could contribute $6,000 to one account, or $3,000 to each, but you cannot contribute $6,000 to each.
2. 401(k)s and Similar Accounts
A 401(k) is an employer-sponsored retirement account.
Similar to IRAs, both traditional (pre-tax) and Roth (after-tax) versions of a 401(k) plan exist, but the availability of them depends on what your employer offers. The traditional 401(k) is much more common.
One of the biggest differences between a 401(k) and an IRA is that a 401(k) is an employer-sponsored account, and that your contributions can be more easily automated. You tell your employer how much you want to contribute, and they will automatically withhold that money from your paycheck and deposit it into your 401(k) for you.
Similar to IRAs, there are rules to be aware of with 401(k)s:
- Max Contributions: In 2021, the maximum annual contribution for any individual is $19,500, while the maximum contribution between the individual and employer is $58,000 annually.
- Withdrawal Rules: Money withdrawn before age 59.5 has a 10% additional penalty.
- Mandatory Withdrawals: Similar to Traditional IRAs, you must start withdrawing from the plan at age 72 to avoid penalties (if you were born after June 30, 1949).
The biggest benefit to a 401(k) is that it oftentimes comes with an employer match.
An employer match is a contribution that your employer makes to your account on top of what you contribute. For example, your company may match 50% of the first 6% you contribute, which would equate to an extra 3% contributed to your retirement account!
For someone making $50,000 annually and contributing 10% to their 401(k), instead of investing $5,000 annually, they’d actually be investing $6,500 thanks to the employer match!
The employer match does vary by company, and some don’t offer it at all, unfortunately. But you should 100% take advantage of it if you have it!
For those who work at a company that does not offer a 401(k), you may have some other, similar options available to you:
- 403(b) plans are similar to 401(k)s, but are available to employees of tax-exempt organizations such as public schools, religious organizations, and hospitals.
- 457 plans are similar to 401(k)s, but are available to state and local government officials and some non-profits.
- Solo 401(k)s are similar to 401(k)s, but are available to business owners with no employees.
3. 529 Accounts
529 Accounts are after-tax accounts designed for saving for college and other qualified education expenses.
You can save and invest on behalf of a beneficiary using after-tax contributions, and when the money is used for qualified education expenses, it can be withdrawn tax-free.
Every state offers a different 529 account, sometimes offering more than one, and you have the option to utilize accounts from other states on top of your own. The benefits of a 529 account can vary slightly by state as well, so it’s likely wise to shop around and find the best 529 account for your needs.
4. Health Savings Accounts
Last on the list of the most popular tax-advantaged accounts are Health Savings Accounts.
A health savings account, or HSA for short, is an account you can set up to pay for out-of-pocket medical costs and health care expenses.
In order to qualify for an HSA, your health insurance plan must be a high deductible health plan. If you qualify, you can then open an HSA through your employer and have them automatically contribute funds on your behalf, or you can open an HSA on your own.
The larger rule to be aware of with HSAs is the annual contribution limits:
- Max Contributions: In 2021, the annual contribution limit to an HSA is $3,600 for someone on a self-only plan. The maximum contribution limit is $7,200 if you’re on a family plan.
The biggest perk of an HSA is that it is both tax-exempt and tax-deferred.
You have the option to use your HSA as a retirement savings account, or you can invest your money. The money you contribute is done on a pre-tax basis, and you can also withdraw your funds tax-free assuming you use them for qualified medical expenses.
Even the investment growth can be withdrawn tax-free if it’s used for qualified health care costs!
However, even if you don’t use the money for qualified medical expenses, after retirement age you can withdraw your money without any penalty. You will just need to pay ordinary income taxes, similar to a 401(k).
Those not eligible for an HSA might be able to contribute to a Flexible Spending Account, or FSA.
An FSA is similar to an HSA in a lot of ways, including the fact that you can contribute pre-tax earnings to the account to pay for qualified health care costs.
However, somewhat ironically, the money does not roll over year after year. If you don’t use the money in the year you save it, you lose it, which doesn’t seem very flexible to me!
Should You Always Use Tax-Advantaged Accounts?
This is a common string of questions I hear when it comes to retirement accounts:
- Should I really be using tax-advantaged accounts?
- Aren’t they less flexible?
- Do I need to max them out?
Let’s break down the answers to those questions:
Should I Really be Using Tax-Advantaged Accounts?
Without a doubt, if you are eligible and have access to them, you should be using tax-advantaged accounts. They are the best tool available to you to build retirement savings, which everyone needs to do.
If you’re not sure where to start and have all of the options listed above available to you, below is a good rule of thumb in terms of the order in which to consider your options:
- Get the employer match in a 401(k)
- Max out an IRA
- Contribute to an HSA
- Save in a 529 Account (if you have a kid and plan to pay for their future education)
- Go back and max out your 401(k)
On step two, most people opt for a Roth IRA, but depends on your tax situation now and how you think income taxes will change in the future (anyone’s best guess).
And if one of the options isn’t available to you, just skip it. For example, if you don’t have a child that you are saving for college for, skip step four.
Aren’t They Less Flexible?
All tax-advantaged accounts come with some set of rules. That is the tradeoff to getting a break on your taxes.
The opposite of a tax-advantaged account is a brokerage account. A brokerage account is a taxable account – you don’t receive any tax savings, but you have maximum flexibility.
You can contribute as much money as you would like and withdraw it whenever you like.
Do I Need to Max Them Out?
No, but it’s not a bad idea if you can.
I previously wrote an article on if you should max out your 401(k), and a lot of the same things I outlined there apply to tax-advantaged accounts in general.
Before maxing out any retirement account, you need to get your overall personal finances in order, which means paying down any bad debt, saving an emergency fund, getting necessary insurance, and ensuring your short term goals are covered.
One example of a short term goal could be saving for a house. If after maxing out all tax-advantaged accounts you are only left with $100 in savings every month, it will probably take you a long time to save up a down payment. It might be smart to actively make the decision to not max out your retirement accounts so that you can save money for a house and accomplish that short term goal.
From there, it becomes a decision of if you need flexibility before retirement age, or if you want all the tax advantages you can get?
The answer will help inform how much, if anything, to put into a brokerage account or non-tax advantaged investment before maxing out your tax-advantaged options.
Bonus: Tax-Advantaged Investments
On top of tax-advantaged accounts, tax-advantaged investments also exist.
The most common tax-advantaged investments are municipal bonds, or muni bonds.
Muni bonds are local investments that are used to support projects like roads, parks, and schools. To incentivize investors to purchase muni bonds, the interest paid on them is not taxed by the federal government. Oftentimes, if you reside in the same state as where the bond is issued, you won’t pay state taxes on them either.
So remember, if you are investing in muni bonds, do so in a brokerage account! Do not put tax-efficient investments within a tax-advantaged account.
There is no need to waste part of your $6,000 annual contribution limit in an IRA on a muni bond, because you would be unnecessarily double-dipping on the tax advantaged status of both the investment and the account.
Summary: Tax-Advantaged Accounts
While this is not an exhaustive list of every tax-advantaged account in existence, it does highlight the major accounts that a majority of investors should consider when planning for retirement.
Tax-advantaged accounts are one of the best tools for retirement out there. If you have access to them, you should be taking advantage of them to set yourself up for future financial success!