Tax-Advantaged Accounts: How They Can Boost Your Savings
Tax-advantaged accounts provide tax benefits to people saving for certain expenses or goals. There are two basic types of tax-advantaged accounts – tax-deferred and tax-exempt accounts. Tax-deferred accounts come with tax breaks when you put money into the account, while tax-exempt accounts offer them when you take money out. In both cases, earnings aren’t taxed while they remain in the account.
Key Takeaways
- Tax-advantaged accounts can offer tax benefits – such as deductible contributions, tax-free growth, and tax-free withdrawals – for people saving for specific purposes like retirement, education, or medical expenses.
- There are primarily two types of tax-advantaged accounts – tax-deferred accounts, which defer taxes until withdrawal, and tax-exempt accounts, where contributions are taxed but withdrawals are tax-free if all the account rules are followed.
- Common tax-advantaged accounts include 401(k) accounts, IRAs, HSAs, 529 plans, and more, each with specific rules for eligibility, contributions, withdrawals, and the like.
- While tax-advantaged accounts offer significant tax benefits and can boost savings in the long run, they can also come with certain restrictions, such as limits on contributions, penalties for non-qualified withdrawals, and required minimum distributions.
Why you should consider tax-advantaged accounts
When saving or investing for future expenses, people tend to focus on market conditions, interest rates, diversification, fees, liquidity, and similar factors when choosing where to put their money. But there’s another important consideration that often gets overlooked – taxes.
It’s great to find a savings account with a high interest rate or a mutual fund with a solid history of growth. That can mean more money in your pocket. But you also should be thinking about the income taxes you’ll have to pay on those earnings, which is money coming out of your pocket.
That’s where tax-advantaged accounts come into play. While not without potential drawbacks, they combine savings and investment gains with tax breaks that can help you lower your tax bill and save more money in the long run.
So, if you’re saving for retirement, college, medical expenses, or other purposes, make sure you check out the tax-advantaged accounts available to you. In the end, the total amount of money you have for these future costs may be higher because less tax is being paid on your savings.
What is a tax-advantaged account?
A tax-advantaged account is simply a financial account that comes with tax benefits, such as tax deductible contributions, tax-free growth, and/or tax-free withdrawals. These tax breaks are designed to encourage saving for specific goals or expenses.
There are generally two types of tax-advantaged accounts: tax-deferred and tax-exempt accounts. In both cases, earnings aren’t taxed while they remain in the account (and they’re usually tax-free even after being withdrawn from tax-exempt accounts). However, the two types of accounts differ when it comes to when you get a tax break and when you pay taxes.
With a tax-deferred account (sometimes called a “pre-tax” account), you generally get a tax break when you put money in the account. But you have to include withdrawals from the account in your taxable income. So, in essence, taxes on your contributions and earnings are “deferred” until you use the funds in the account.
On the other hand, there are no tax breaks when you put money in a tax-exempt account (also known as an “after-tax” account). But you're generally rewarded with tax-free withdrawals from the account, assuming you follow all the rules for that particular type of account. So, taxes are paid upfront and your tax benefits come later.
There are even tax-advantaged accounts that provide both tax benefits when you put money into the account and when you take it out.
Tax benefits of tax-advantaged accounts
Let’s dive a little deeper into the different types of tax benefits available with tax-advantaged accounts.
Tax-free contributions with tax-deferred accounts
With taxable accounts – like standard brokerage accounts or savings accounts – there are no tax breaks when you put money into the account. But your contributions typically avoid taxation when you put money in a tax-deferred account.
If you're making the contribution yourself, your tax break typically comes in the form of a tax deduction. You can claim the deduction when you file your federal income tax return for the year you made the contribution.
Contributions you make through payroll deductions, or employer contributions to a tax-deferred account, aren't included in your taxable income. So, when you receive your W-2 form for the tax year of the contribution, the taxable wages reported in Box 1 won't include the money that went into your tax-deferred account.
Your adjusted gross income (AGI) for the year will also be lower because of the tax deduction or reduced taxable income. This will directly lower your tax bill, and it could also open up other tax breaks that have AGI-based eligibility rules. You might also avoid the reduction of tax deductions or credits that are phased-out for people with an AGI above a certain amount.
You’ll eventually have to include money contributed to a tax-deferred account and any earnings in your taxable income. But that won’t happen until you withdraw funds from the account.
Tax-free growth with tax-advantaged accounts
Earnings on “regular” savings and investments are often taxed when you receive them. For example, if you open a savings account with a bank, the interest you earn each year is taxed in the year you earn it. The same is generally true for dividends paid into a standard brokerage account.
However, with a tax-advantaged account, there’s no tax on earnings between the time you contribute to the account and withdraw funds from it. This is true for both tax-deferred and tax-exempt accounts.
The earnings are eventually taxed when withdrawn from a tax-deferred account. But they’re generally not taxed at all with tax-exempt accounts (assuming all the account rules are followed).
Tax-free withdrawals with tax-exempt accounts
If you sell stock or other assets held in a standard brokerage account and pocket the proceeds, you typically have to pay capital gains tax on the profit. But if those same assets are held in a tax-exempt account, there typically isn’t any tax on your withdrawal – as long as you satisfy the requirements for the type of tax-exempt account you own.
One common requirement is that you use the withdrawn funds for a specific purpose, such as for qualified education or medical expenses. With retirement accounts, you can be hit with a penalty if you withdraw money before turning 59½ years old. Other rules and restrictions may also apply.
Common tax-advantaged accounts
While tax-advantaged accounts can be used for other purposes, most people open them to save for retirement, education expenses, or medical costs. So, let’s take a quick look at a few of the more common tax-advantaged accounts for these three savings goals.
401(k) accounts
A 401(k) account is a retirement savings account that’s sponsored by many employers. If you sign up for your employer’s 401(k) plan, contributions will be withheld from your paycheck and deposited into your account. Your employer might even match your contributions – up to a point.
Both tax-deferred (“traditional”) and tax-exempt (“Roth”) 401(k) accounts are allowed. With a traditional 401(k) plan, money put in the account isn’t included in your taxable income. Money in the account grows tax-free, but both contributions and earnings are taxed when you withdraw funds from the account.
If you have a Roth 401(k), the money taken out of your paycheck and put into the account is included in your taxable income. But withdrawals are completely tax-free if you’re at least 59½ years old and have held the account for at least five years (otherwise, the earnings portion of your withdrawal is subject to tax and perhaps a penalty).
IRAs
Individual retirement accounts (IRAs) are another popular type of retirement account. As with 401(k) plans, there are both traditional IRAs (tax-deferred) and Roth IRAs (tax-exempt). However, unlike 401(k) accounts, which are run through your employer, you can open and manage an IRA all on your own.
Contributions to a traditional IRA are generally deductible. However, the IRA deduction can be reduced – or even eliminated – if you or your spouse have access to a 401(k) or other employer-sponsored retirement plan and your income is greater than a certain amount. You pay tax on all withdrawals from a traditional IRA.
There’s no tax deduction for contributions to a Roth IRA. However, if you’re 59½ or older and first contributed to a Roth IRA at least five years ago, you can make tax-free withdrawals. If you don’t meet these requirements when you take money out of a Roth IRA, you’ll owe tax on the earnings portion of the withdrawal.
TurboTax Tip:
If you put money into an IRA or 401(k) account, you might also qualify for the Saver’s Credit, which is designed to encourage lower- and middle-income people to save for retirement. The credit is worth up to $1,000 ($2,000 for married couples filing a joint return).
529 plans
Millions of Americans use tax-exempt 529 plans to save for college and other education-related expenses for their child or another beneficiary. States generally sponsor 529 plans, and you might be able to get a state income tax deduction or credit if you contribute to your state’s plan.
There’s no federal tax breaks when you put money into a 529 account – but you won’t pay tax on your contributions or earnings if you use the money in your account to pay for qualified higher education expenses.
A 529 plan isn’t just for college costs, either. Up to $10,000 per year can be used to pay for tuition at an elementary, middle, or high school.
There are also a number of options available if there’s money leftover in a 529 account after the beneficiary is done with school. For instance, it can be transferred to a family member’s 529 account, rolled over to a Roth IRA in the beneficiary’s name (up to $35,000), or used to pay the beneficiary’s student loans (up to $10,000).
Coverdell ESAs
There’s another tax-exempt account you can use to save for education costs – a Coverdell education savings account (ESA). They’re similar to 529 plans in that there’s no deduction for contributions to the account, while withdrawals are tax-free if the money is used for qualified education expenses.
However, there are some notable differences between Coverdell ESAs and 529 plans. For instance, with a Coverdell ESA:
- Funds can be used for more than just tuition at an elementary or secondary school, and there’s no limit on how much you can withdraw for these expenses.
- The amount you can contribute each year is reduced (or even eliminated) if your income is above a certain amount.
- You generally have to put money in the account before the beneficiary turns 18.
- When the beneficiary turns 30, you generally have to take out all the money in the account within 30 days.
HSAs
Health savings accounts (HSAs) are used to save for future medical expenses. But they’re a bit unique in that they provide tax benefits both when you put money in the account and when you take it out.
Contributions you make to an HSA are generally tax deductible. Some employers will make contributions to your HSA, too. In that case, the contributions aren’t included in the taxable income reported on your W-2 form.
There’s also no tax on withdrawals as long as the money is used to pay qualified medical expenses, which are basically the same as expenses that qualify for the medical and dental expenses deduction (but you can’t use the same expense for both an HSA distribution and the medical expense deduction).
Health FSAs
Health flexible spending accounts (FSAs) allow employees to set aside money to pay for eligible health care expenses. Like HSAs, they’re both tax-deferred and tax-exempt accounts. However, FSAs are only available if your employer sets it up, so you can’t open one by yourself.
FSAs are typically funded through payroll deductions, with the employee choosing how much to contribute from each paycheck (up to an annual limit). But your employer can contribute to your FSA, too. Contributions to an FSA aren’t included in your taxable income.
Money in your FSA can be used to pay for medical expenses (or be reimbursed for them). As long as they’re used to pay qualified expenses, there’s no tax on withdrawals from your FSA.
However, FSAs are generally "use-it-or-lose-it" accounts. This means any amount left in the account at the end of the year generally can’t be carried over to the next year (although your employer can offer a limited grace period or carryover amount).
Other tax-advantaged accounts
While the accounts listed above may be the most common types of tax-advantaged accounts, they aren’t the only ones. Here are some other accounts that can help savers cut their tax bill.
- Solo 401(k) - A 401(k) retirement account for a business owner with no employees, or only one employee who is a spouse.
- 457 accounts - Similar to 401(k) retirement accounts, but for government workers and employees of certain tax-exempt organizations.
- 403(b) accounts - Similar to 401(k) retirement accounts, but for employees at public schools and certain charities.
- Simplified Employee Pension (SEP) IRAs - Special type of IRA set up by employers. Only the employer contributes to an employee’s retirement account.
- Savings Incentive Match Plan for Employees (SIMPLE) IRAs - Special type of IRA set up by small businesses. The employer must contribute to each eligible employee’s retirement account, while employees have the option to contribute.
- Achieving a Better Life Experience (ABLE) accounts - Similar to a 529 account, but for costs to maintain health, independence, and quality of life for people with disabilities or who are blind.
- Dependent care FSAs - Similar to a health FSA, except funds are used to pay for eligible child and dependent care expenses.
Drawbacks of tax-advantaged accounts
While tax-advantaged accounts can offer great tax benefits, they aren’t without certain downsides. For example, when compared to taxable accounts, you might lose some flexibility with tax-advantaged accounts. You can also lose the very tax benefits that make these accounts unique.
Here’s a quick look at a few of the drawbacks of tax-advantaged accounts that you want to keep in mind.
Restrictions on use of funds
As already mentioned, tax-advantaged accounts are designed to encourage saving for specific expenses or goals – like retirement, higher education, or medical costs.
If you don’t use funds from a tax-advantage account for the intended purpose, you can be penalized. For example, if you don’t use money from a 529 plan or Coverdell ESA for qualified education expenses, you’ll lose the tax exemption normally allowed for withdrawals and might have to pay a penalty.
Likewise, since IRAs and 401(k) accounts are used to save for retirement, you can be hit with a 10% early withdrawal penalty if you pull money out of these accounts before you reach age 59½ (although there are several exceptions to the penalty). If you have a Roth account, you can also lose the tax exemption on earnings if you withdraw funds from your retirement account early (your contributions to a Roth account can be taken out at any time without penalty).
There’s one notable exception to the penalty rules for seniors with an HSA. If you’re at least 65 years old, you can withdraw money from an HSA and use it for any purpose without having to pay a penalty - although you’ll still have to pay tax on the withdrawal.
Contribution limits
You can stuff as much money in a regular taxable account as you want. But there are limits to how much you can put in tax-advantaged accounts. Exceeding the contribution limit can result in the loss of tax benefits and penalties.
In most cases, there are annual contribution limits for tax-advantaged accounts. In some cases, the limit is increased if you’re at least a certain age (the extra amount is called a “catch-up” contribution). For instance, you generally can’t put more than $7,000 in one or more IRAs for the 2024 tax year if you’re under 50 years old, or $8,000 if you’re 50 or older ($6,500 and $7,500, respectively, for 2023). The limits are updated each year to account for inflation.
In some cases, the annual contribution limit can also be reduced – potentially to $0 – if your income is above a certain amount. This is the case with Roth IRAs and Coverdell ESAs.
Your IRA contributions for the year also can’t exceed your taxable compensation for the year.
When it comes to 529 plans, the contribution limits apply to your overall contributions, rather than annual contributions. The limits, which are set by the states that authorize 529 plans, are also based on the amount typically needed to cover the plan beneficiary’s qualified education expenses in that state.
As a result of these limits, tax-advantaged accounts might not fulfill your needs if you’re trying to save a large amount of money each year.
Required minimum distributions (RMDs)
Since money in a tax-deferred account isn’t taxed until you withdraw it, the IRS forces you to start withdrawing funds from traditional IRAs and 401(k) accounts once you reach a certain age. These mandatory withdrawals are called “required minimum distributions” (or RMDs for short).
Right now, you don’t have to start taking RMDs until you’re 73 years old. However, RMDs won’t be required until you turn 75 starting in 2033.
RMDs aren’t required for Roth IRAs or, starting in 2024, Roth 401(k) accounts. They aren’t required for taxable accounts, either. So, if you want to keep all your retirement savings in your account past the age when RMDs kick in, consider opening a Roth account or even a taxable account.
Eligibility requirements
Even if you want to save with a tax-advantaged account, you might not meet the eligibility requirements for opening or contributing to the account. For instance:
- You might not be able to participate in your employer’s 401(k) plan if you’re a part-time worker.
- You must have earned income for the year to contribute to an IRA.
- Contributions to a Roth IRA or Coverdell ESA aren’t allowed if your income is too high.
- You can’t contribute to an HSA unless you’re covered under a high-deductible health plan.
- You generally can’t open a Coverdell ESA for a beneficiary who is 18 or older (unless the beneficiary has special needs).
The point is to make sure you check out the rules for the type of account you’re interested in before mapping out your savings plan.
Limited investment options
Investment options can be limited with certain tax-advantaged accounts. For instance, 401(k) plans and 529 accounts typically offer a limited number of mutual funds or other investment options to choose from.
While IRAs typically offer a wider selection of investment choices, you generally can’t use them to invest in collectibles, such as art, stamps, coins, gems, precious metals, and the like.
How to choose the right tax-advantaged account
After weighing the pros and cons, you decide to move forward and open a tax-advantaged account. How can you pick the right account for you?
Assess your financial situation and goals
A good place to start is with an assessment of your current financial situation and financial goals for the future. Ask yourself a few questions about your goals and tax expectations, such as:
- What are you saving for?
- How much do you need to save?
- What’s your timeline?
- If you have multiple goals, what are your priorities?
- Do you need a tax break now more than you will in the future?
- Will a tax break be more valuable now or in the future?
Once you’ve gone through these and similar other questions, it will be easier to evaluate the different types of tax-advantaged accounts and pick the right one(s) for you.
Tax break now vs. tax break later
When deciding whether to put money in a traditional or Roth retirement account, one thing to consider is the comparative value of the tax benefits available. Will the tax break you get when you contribute to a traditional account be worth more than the tax break you get when you withdraw funds from a Roth account?
Generally speaking, if you expect to be in a lower tax bracket when you retire, getting an immediate tax break when you contribute to a traditional account will be more valuable than a tax break later when you withdraw money out of a Roth account.
For example, if you’re in the 22% tax bracket right now, you’ll cut your tax bill by $2,200 if you contribute $10,000 to a traditional retirement account ($10,000 x .22 = $2,200). But if you expect to be in the 12% bracket when you retire, you’ll only save $1,200 when you pull $10,000 out of a Roth account in retirement ($10,000 x .12 = $1,200).
Of course, if the script is flipped and you expect to be in a higher tax bracket in retirement, then a Roth account might be the way to go. Plus, if one of your primary goals is to minimize taxes in retirement as much as possible, then a Roth account is the better option – even if the value of the tax benefit is lower.
But keep in mind that income tax rates can change – especially if you’re trying to predict which tax bracket you’ll be in decades from now. Future tax rate changes can impact the effectiveness of your retirement saving strategy.
And, of course, you can always save for retirement with both traditional and Roth accounts. Having a mix of both tax-deferred and tax-exempt accounts can offer more flexibility now and in the future.
Evaluating eligibility and contribution limits
As noted earlier, tax-advantaged accounts can have specific eligibility requirements. So, naturally, you want to make sure you qualify before opening a specific type of account.
You also want to make sure you’ll be eligible for the available tax break before opening a tax-advantaged account. For instance, you might think twice before opening a traditional IRA if you have a 401(k) at work and your income is above the point at which the tax deduction for contributions to a traditional IRA are completely phased out.
Pay attention to a tax-advantaged account’s contribution limits, too. If the limit is too low to accommodate your savings goals, then you might want to look for a different option. Also remember that annual contribution limits for certain types of accounts – such as Roth IRAs and Coverdell ESAs – can be phased-out for people with higher incomes.
Consult a financial advisor
You can always bring in an expert to help if you’re not sure which accounts are right for you. Working with a tax professional or other financial advisor can also result in greater tax savings and a saving strategy that’s designed specifically for you.
Tips for optimizing tax-advantaged accounts
Making the most of your tax-advantaged accounts can significantly impact your long-term financial well-being. Here are a few quick tips to help you grow your tax-advantaged accounts while keeping them in line with your financial goals.
Regularly contribute to your accounts
Make regular contributions to your tax-advantaged accounts a priority. If possible, set up automatic contributions to your accounts to make sure you’re constantly funding them. That way, you won’t even have to think about it.
Take advantage of employer matching
If your employer offers a matching contribution to your 401(k) or other retirement plan, make sure you contribute at least enough to get the full match. This is essentially free money and can significantly boost your retirement savings.
Utilize catch-up contributions
If you’re at least 50 years old, you can make catch-up contributions to retirement accounts like IRAs and 401(k) accounts. Use this opportunity to boost your retirement savings, especially if you started saving later in life or have additional income to put towards retirement.
Catch-up contributions to HSAs are also allowed if you’re 55 or older.
Strategically plan withdrawals
Since money taken out of a tax-deferred account is included in your taxable income, it can potentially push you into a higher tax bracket. In this situation, delaying the withdrawal to the following year – if possible – might result in an overall tax savings (assuming you won’t run into the same problem next year).
If you’re retired and have both traditional and Roth accounts, you can withdraw money tax-free from your Roth accounts – instead of from your traditional accounts – to avoid being bumped into a higher tax bracket and potentially increase the amount of your Social Security benefits that are subject to tax.
Regularly review your accounts
It’s a good idea to periodically review your tax-advantaged (and other) accounts. An annual review is generally recommended to make sure your investments continue to align with your long-term goals and risk tolerance.
Also check to see if your investments are diversified, which can help protect your savings against market volatility.
Periodically rebalancing your investments is also wise. This involves buying or selling assets to bring your portfolio back to its original risk level.
Stay up-to-date on tax law changes
Tax laws can change. Contribution limits and phase-out thresholds are also updated annually to account for inflation. That’s why it’s important to stay informed about any changes that can impact your contributions, withdrawals, RMDs, and other aspects of your tax-advantaged accounts.
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