There's a reason why financial advisors routinely recommend sticking your long-term savings into one or more tax-advantaged accounts to help optimize your earnings: it works.
When you route a chunk of your pre-tax income into a tax-deferred retirement plan, such as a traditional IRA or a 401(k), you help relieve pressure from your budget by lowering your taxable income. But you also give your savings more time to grow tax-free until you're ready to retire.
Similarly, tax-free savings accounts, such as an HSA or 529 Plan, can help supercharge your savings by allowing you to skip paying taxes altogether on the income you use to pay for qualified health or educational expenses.
But not all tax-advantaged accounts are alike. It pays to learn the difference between the different account types so that you can pick the right option to match your financial goals and circumstances. Here's a closer look at what you should know about tax-advantaged savings accounts.
What are Tax-Advantaged Accounts?
A tax-advantaged account is a dedicated savings vehicle that's specially designed to give you extra tax benefits in exchange for saving money. Specifically, any type of investment, financial account, or savings plan that is tax-exempt (free from taxes), tax-deferred (you pay taxes later), or offers other types of tax benefits falls under the umbrella of tax-advantaged accounts.
For example, Congress helped spur the creation of employer-sponsored 401(k) plans by adding a provision to the Revenue Act of 1978 that allows employees to delay paying taxes on a portion of their saved earnings. Similarly, Congress has repeatedly amended section 529 of the Internal Revenue Code to help encourage families to set aside funds for educational expenses in a tax-advantaged account known as a 529 Plan.
The purpose of a tax-advantaged savings account is to give you an added financial incentive to save money for important life expenses, such as health, education and retirement. In addition, many employers offer company-sponsored tax-advantaged plans as another employee benefit.
Types of Tax-Advantaged Accounts
Plans vary widely depending on how they are sponsored and what they are designed to hold. Here are the main types of tax-advantaged accounts available to savers:
1. Retirement Plans
One of the best-known retirement account options is an employer-sponsored qualified retirement plan known as a 401(k), which helps employees grow their retirement savings through targeted investments, such as stocks and bonds.
A 401(k) is typically funded through a combination of employer contributions and voluntary deductions from an employee's paycheck. For example, an employer may offer a 401(k) match benefit that allows you to direct a certain percentage of your paycheck to your 401(k) and the employer will match it with an equivalent contribution.
Some employers offer similar tax-advantaged plans, such as 403(b) plans for employees of tax-exempt non-profits and 457(b) plans for state and municipal employees.
If you're self-employed or have already maxed out your 401(k) contributions and have more money to sock away, you may choose another retirement savings vehicle called an IRA. Short for Individual Retirement Arrangement, an IRA is an independent retirement plan that you can open with any financial institution that offers it.
For example, RVC offers a range of high-yield IRA account options, including an IRA Money Market Account and an IRA Certificate of Deposit. Depending on the retirement plans sponsored by your employer and whether they match your contributions, you may even find that an IRA offers more value than a 401(k).
The tax benefits from a tax-advantaged retirement plan will depend, in part, on whether you choose a traditional 401(k) or IRA — both of which are tax-deferred savings plans — or a Roth IRA or after-tax 401(k), which are tax-exempt (See below for more details on what sets a tax-exempt account apart from a tax-deferred one).
2. Education Plans
If you have kids or want to sponsor another family member's education, setting aside money for their expenses in a tax-advantaged account is a great way to boost savings while trimming your tax bill.
For example, a 529 Plan allows you to set aside pre-tax income in a tax-advantaged account and withdraw it tax-free when it's time to pay for qualifying educational expenses. You can use the funds you've saved through a 529 Plan to pay for college or K-12 private school tuition, fund an apprenticeship or repay student loans.
Some participating colleges and universities also let you prepay tuition by purchasing credits that you can redeem in the future. Or you can park your savings in an investment account that's earmarked for education. So long as you use your savings to pay for qualified educational expenses, you won't have to pay a dime in other taxes.
A Coverdell Education Savings Account works similarly, but the money you use to fund it won't be tax-deductible. Instead, you'll enjoy tax savings on the money you've earned through your investments since the funds can be withdrawn tax-free and as long as they're used for college or K-12 tuition or for other qualifying educational expenses.
3. Health Plans
Setting aside money for health expenses in a tax-advantaged account is another popular way to reduce taxable income while growing your savings for big life expenses.
For example, a Health Savings Account (HSA) works a lot like a 529 Plan: any pre-tax income you put into your HSA will remain tax-free so long as you use it for qualified medical expenses. That means you'll be able to deduct those savings from your current tax bill and grow your investments without worrying about future taxes.
Benefits of Tax-Advantaged Accounts
A tax-advantaged savings account offers a sure-fire way to lower how much you pay in taxes while increasing your long-term savings. Depending on the account you choose, you could be surprised by how much you save just by deferring or skipping taxes.
Some other leading benefits of a tax-advantaged account include:
• More choice. It's nice being able to pick when and how you'll pay taxes on portions of your income. When your budget is tight and your expenses are complicated, reducing your current tax load through a tax-deferred account can be a huge stress reliever. But if you prefer going into retirement with as few bills as possible, the option to pay now instead of later can help take pressure off the future.
• More predictability. If you're concerned about state and federal tax hikes and don't want to get stuck paying a higher tax rate on old income, then you'll also appreciate being able to store at least some of that money in a tax-exempt account.
• Meaningful incentives. Money is motivating, which is why governments have put so many financial incentives in place to encourage healthy savings.
Tax-Deferred Account vs. Tax-Exempt vs. Tax-Free
Depending on what you're saving for, you may be asked to choose between a tax-deferred account or a tax-exempt account. Here's a breakdown of the key differences.
Tax-deferred accounts
Tax-deferred accounts let you put off paying taxes on your earnings until it's time to withdraw. But the downside is you must pay taxes on that income when you withdraw it – potentially at a higher rate than if you had already paid taxes on it.
Tax-exempt accounts
On the other hand, tax-exempt accounts require you to pay taxes upfront, just like regular income. But you won't have to pay taxes going forward. So you can grow your investments tax-free.
Tax-advantaged account with tax-free withdrawals
This type of account, such as a health savings account or a 529 plan, offers the best of all worlds. You can deduct your taxes from your income, reducing your tax burden. But you don't have to worry about paying future taxes either, as long as you use the money you withdraw on qualifying expenses.
Best Tax-Advantaged Accounts
If you're interested in tax-advantaged accounts, reach out to a Riverstones Vista Capital advisor to request more information. But here's a snapshot of the best tax-advantaged accounts currently available on the market:
| HEALTH |
|
| Health Savings Account (HSA) |
· Save money on taxes by setting aside pre-tax income for health expenses. · Make additional tax-deductible contributions at any time. · Watch your savings grow tax-deferred while invested. · Withdraw money tax-free for qualified medical expenses. |
| Flexible Savings Account (FSA) |
· Grow your savings with pre-tax income. · Withdraw money tax-free for qualified expenses. |
| EDUCATION |
|
| 529 |
· Save money for a child's education while enjoying special tax benefits. · Depending on your state, you may also qualify for additional tax breaks. · Watch savings grow tax-deferred while invested. · Withdraw money tax-free for qualified educational expenses. |
| Coverdell Education Savings Account |
· Save money for a child's education while enjoying special tax benefits. · Curb future taxes by setting aside after-tax income. · Watch your money grow tax-free. · Withdraw money for qualified educational expenses without paying additional taxes. |
| RETIREMENT |
|
| Traditional 401(k) |
· Reduce annual tax bill by setting aside pre-tax income for retirement. · Watch your money grow tax-deferred while it's invested. · Put off paying income taxes on that money until you start withdrawing the funds (e.g., in retirement). |
| Roth 401(k) |
· Save money on future taxes by setting aside after-tax income for retirement. · Watch your money grow tax-deferred while it's invested. · Withdraw funds for retirement without paying any more taxes. |
| Traditional IRA |
· Save money on both this year's taxes and future taxes by setting aside pre-tax earnings for retirement. · Watch your money grow tax-deferred while it's invested. · Pay income tax on amounts withdrawn. |
| Roth IRA |
· Pay taxes now instead of later by setting aside after-tax earnings for retirement. · Watch your money grow tax-deferred while it's invested. · Withdraw money tax-free once you've reached retirement. |
| SEP-IRA |
· Save money on future taxes by setting aside after-tax income. · Watch your money grow tax-deferred while it's invested. · Withdraw money tax-free once you've reached retirement. |
Final Say: Are Tax-Advantaged Accounts Worth It?
Absolutely! Tax-advantaged accounts offer a simple and reliable way to boost your savings, reduce your tax burden, and give yourself more control over where your money goes.
Depending on the type of investment strategy you choose, tax-advantaged savings accounts also tend to be low-maintenance and easy to open thanks to their popularity with employers and savers alike. So if you're already planning to put away money for a specific, long-term goal, such as saving for retirement, your child's education or healthcare, a tax-advantaged savings account is a smart place to put it.
But if you're looking for more flexibility with your savings and easier or faster access, then a certificate of deposit (CD) with a strong interest rate or a high-yield savings account may be a better option.
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Kelly Dilworth is a business and personal finance reporter, specializing in the intersection between money and life. She has covered consumer banking and lending for more than a decade and particularly enjoys writing about consumer behavior and psychology, new consumer research and how everyday banking products impact people's lives.