While each of us has our own set of financial goals and objectives, one smart strategy can be beneficial in any number of situations: tax-advantaged accounts. These are accounts such as IRAs, 401(k)s and HSAs—accounts specifically designed to help reduce your tax burden, whether that’s a benefit you feel today or years from now.
Interested in putting one or more of these financial tools to work for you? Here’s what you need to know.
What Are Tax-Advantaged Accounts?
Tax-advantaged accounts are just what the name suggests—financial accounts that offer tax advantages. These savings vehicles are designed to encourage savings while helping to minimize tax burdens and maximize growth.
There are two types of tax-advantaged accounts:
- Tax-deferred accounts are those you fund with pre-tax income. Contributions are not taxed when added to the account, but you will pay ordinary income taxes on any money withdrawn from the account. If you are under 59½, you will also pay a 10% early withdrawal penalty in most instances.
- Tax-exempt accounts are funded with after-tax money, which means you won’t have to pay any taxes on the principal (contributions) or embedded gains when you take a distribution. These are generally the most valuable types of accounts for an investor to have.
When deciding which accounts are right for you, I recommend seeking counsel from a financial advisor and tax professional. But to get you started, here are some common tax-advantaged financial vehicles and tips on using them to their greatest benefit.
Tax-Deferred Accounts
401(k) or 403(b) accounts
These are accounts most people are already familiar with. A 401(k) is offered through private employers, while a 403(b) is the nonprofit and government equivalent. Typically, the account contribution will come directly from your paycheck before taxes, which makes them a convenient way to save.
Many companies even offer a match, usually up to a set percent of your income, which means you’re making money even before realizing any market return. That’s why I recommend saving at least up to the match amount, even if you decide to focus the rest of your savings elsewhere.
Traditional IRAs
Contributions to a traditional IRA may be tax-deductible in the year they were made, depending on your income and whether your employer offers an account like a 401(k). Distributions will then be taxed at ordinary income rates when you make withdrawals. IRAs are appealing because of the wide number of investment options and can be a good add-on to other savings strategies.
529 Plans
These plans are a popular place to build college savings that will grow tax-deferred, and withdrawals are withdrawn tax-free as long as the funds are used for qualified educational expenses. With some plans, you may also qualify for a state tax deduction. However, only contribute to a 529 plan if you’re also simultaneously saving for retirement. After all, you can borrow for school but not for retirement.
One great way to fund 529 plans is to ask relatives to contribute. For affluent grandparents, it can be a good way to draw down their estate using the gift tax exemption. They can even contribute a larger lump sum and spread it over as many as five years for tax purposes.
Flexible Spending Accounts (FSAs)
Many employers offer FSAs, allowing you to contribute pre-tax money that can then be withdrawn tax-free and used for out-of-pocket healthcare costs that your insurance may not cover. Be aware that most plans, however, have a stipulation that you use it by the end of the year or lose it, so you don’t want to overfund the account. But if you know your child will be getting orthodontic treatment or you have planned a medical procedure, it can be a good way to cover eligible expenses with pre-tax savings.
Life Insurance
While life insurance isn’t an investment choice that suits everyone’s needs, it’s another option to consider. Universal, variable, and whole life policies build cash value while also providing for your loved ones in the event of a tragedy. The death benefit is typically tax-free, and the value of your account grows tax-free.
Tax-Exempt Accounts
Roth IRA
With a Roth IRA, you contribute after-tax dollars and then won’t have to pay any taxes when you eventually withdraw that money if certain requirements are met. For that reason, Roth IRAs are widely considered one of the most valuable accounts an investor can own.
There are income limits to a contributory Roth IRA, so not everyone qualifies. However, there is a commonly used strategy known as a backdoor Roth contribution that can act as a workaround. This involves a two-step process—making an after-tax contribution to your traditional IRA and then transferring those funds shortly thereafter to your Roth IRA. You can also perform a Roth conversion at any time and at any income level.
Roth 401(k)
Some employers offer a Roth 401(k), which essentially functions the same as a Roth IRA outlined above. There are no income limits on a Roth 401(k), so it can be a good complement to a traditional retirement savings plan.
Health Savings Account (HSA)
HSAs are one of my favorite ways to manage your taxes because they offer three types of tax breaks—a tax deduction when you contribute, tax-free growth, and tax-free distribution. Not everyone can take advantage of them, though. HSAs are only offered as a supplement to a high-deductible health plan (HDHP).
HSA money can be used for qualified medical expenses the health plan doesn’t cover. Unlike an FSA, these funds don’t have to be used within a certain timeframe. And you can submit already-paid medical expenses for reimbursement at any time, as long as you have the receipts.
I find that people routinely overlook the power of these accounts and the tax benefits you’ll enjoy in retirement. Instead of withdrawing monies early on for medical expenses, you can let your money continue to grow, and your HSA essentially becomes a tax-advantaged way to cover medical expenses in retirement.
Be Tax-Smart as You Plan for the Future
All of these types of accounts serve a purpose. The name of the game in building wealth is keeping that long-term perspective and aiming to achieve the lowest tax payment possible. A financial advisor can help you determine which strategies may be worth considering based on your goals for the future. When you’re ready to get started, we’re here to help.
Debra Taylor is not registered with Cetera Wealth Services LLC. Any information provided by this individual is provided entirely on behalf of CWM, LLC and is in no way related to Cetera Wealth Services LLC or its registered representatives.
This content is for general information only and is not intended to provide specific legal, tax, or other professional advice. Investing involves risk, including possible loss of principal. No strategy assures success or protects against loss. To determine what may be appropriate for you, consult with your attorney, accountant, financial or tax advisor.
Some IRAs have contribution limitations and tax consequences for early withdrawals. For complete details, consult your tax advisor or attorney.
Converting from a traditional IRA to a Roth IRA is a taxable event.
Distributions from traditional IRAs and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59½, may be subject to an additional 10% IRS tax penalty.
A Roth IRA offers free tax withdrawals on taxable contributions. To qualify for the tax-free and penalty free withdrawal or earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59½ or due to death, disability, or a first-time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes.
Distributions from employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59½, may be subject to an additional 10% IRS tax penalty.
Investors should also consider whether the investor’s or beneficiary’s home state offers any state tax or other benefits available only from that state’s 529 Plan. Any state-based benefit should be one of many appropriately weighted factors in making an investment decision. The investor should consult their financial or tax advisor before investing in any state’s 529 Plan.
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