Tax-advantaged accounts are investment and savings accounts with special tax properties. They may offer tax-deferred contributions, tax-exempt withdrawals or both. Retirement accounts like 401(k)s and IRAs, educational savings accounts like 529s and HSAs are all examples of tax-advantaged accounts.
With regular brokerage accounts, investors buy assets with after-tax money, then pay capital gains taxes when they sell profitable investments. But tax-advantaged accounts offer investors a chance to make tax-deferred contributions or tax-exempt withdrawals. (And sometimes, both.)
Tax-deferred accounts let you contribute pre-tax income and take a deduction against the current year’s taxes. However, when you make qualified withdrawals, you’ll generally pay earnings on both contributions and gains at your ordinary income tax rate.
Typically, tax-deferred accounts are recommended if you think you’ll be in a lower income tax bracket later.
By contrast, tax-exempt accounts require you to contribute after-tax funds. But any qualified withdrawals – including any dividends, interest or appreciation – are usually not subject to income or capital gains taxes.
Often, tax-exempt accounts are recommended if you think you’ll be in a higher income tax bracket later.
A few specialty accounts let you invest pre-tax income and avoid paying taxes on withdrawals. However, you must spend your withdrawals on qualifying expenses to avoid Uncle Sam.
Tax-advantaged accounts provide financial incentives to build wealth and secure your future. They also come in several varieties so you can save for specific needs.
Tax-advantaged retirement plans encourage saving for the day you exit the workforce. You may have your choice between Roth (tax-exempt) or traditional (tax-deferred) versions of the same plans.
Employer-sponsored retirement plans include 401(k)s, 403(b)s and 457(b)s. These accounts generally deduct funds from your paycheck to contribute to targeted investment funds containing stocks and bonds. Some employers offer contribution matches to increase your saving power.
If you’re self-employed or want to boost your savings, you can also open an IRA (individual retirement account). These accounts offer similar tax advantages, though with smaller annual contribution limits. Some self-employed individuals may also open a solo 401(k).
Tax-advantaged educational accounts let parents and individuals save for various educational expenses.
For instance, 529 plans let you save pre-tax income and make tax-free withdrawals to pay for eligible K-12 or college tuition. Some let you prepay tuition instead, purchasing credits now that students can redeem later.
Coverdell Education Savings Accounts are another option. With these, you contribute after-tax dollars and make tax-free withdrawals to cover qualifying educational expenses.
HSAs, or Health Savings Accounts, are tax-advantaged accounts that earmark funds for medical expenses. They function similarly to 529 plans in that you can enjoy both pre-tax contributions and tax-free withdrawals. However, you must spend the funds on qualifying medical expenses.
Tax-advantaged savings accounts let you reduce your lifetime tax bill and increase long-term savings. While they have stricter rules than standard brokerage accounts, they can be essential for preparing for retirement or large, future expenses.
And did we mention the tax benefits?
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