There are many different tax advantaged accounts, and it’s important to know the difference between them. If you are not familiar with terms such as tax-efficient investing or what a tax advantaged account is, this article will help you learn more about tax advantaged accounts to help you identify which one may be better for your needs.
What is a Tax Advantaged Account?
A tax advantaged account is a type of investment or savings vehicle that provides the investor with benefits such as reduced taxes. Tax advantaged accounts can be established for retirement (IRA), education, health care, and other purposes.
As an investor, you should consider putting your investments in these tax-efficient savings accounts because they are not subject to income taxes until distributed, resulting in lower overall taxation.
Investment Accounts
Investment accounts are a type of account that can be used to invest in stocks, bonds, and other securities.
Investment accounts are usually not taxed until they are withdrawn or distributed from the account. Upon withdrawal, investment earnings will be subject to taxes, including capital gains tax on assets held for more than one year before being sold at a higher price.
There are two types of investment accounts: taxable investments and retirement or taxadvantaged plans such as an IRA (Individual Retirement Account) or 401(k).
1. Taxable Accounts
Taxable accounts are not tax-deferred, and there will be immediate taxation of earnings on investments in the account, which may include capital gains taxes. As a result, taxable accounts are generally seen as riskier than retirement or tax advantaged investment plans because they have a riskier return profile due to possible future changes in federal income taxes. Examples include bank savings, stocks, and bonds.
2. Tax Advantaged Accounts
Tax advantaged accounts are tax-deferred. These accounts can be seen as less risky because the money inside them is not taxed currently and will grow without being taxed until it’s withdrawn in retirement, where taxes may have changed dramatically from today’s levels. Below are examples of TADs:
- Roth IRA: A Roth IRA is an account that offers tax advantages and can be a good investment for retirement. This type of account gives you the ability to grow your money without paying taxes in the short term because these taxes are deferred until you withdraw your money.
- 401(k): If you have a company that offers a 401(K), this can help you save on taxes in the short term. With the current tax rates, these accounts allow employees to make pre-tax contributions up to $18,500 per year into their account and then let it grow without paying taxes on it in the short term because they will need to pay income taxes when they retire or take out their money from the account.
- 403b: Investing your money into a 403b is another option. This type of account can help you save for retirement while giving you tax-deferred growth and the ability to withdraw funds from it without paying taxes on them until you are 59.5 years old.
- Supervised 529 College Savings Plans: If you are looking to fund your children’s education and save for a future expense, investing in a 529 college savings plan can be beneficial. Contributions made into these accounts are not tax-deductible, but earnings on the money inside it grow without taxation until withdrawn.
- Coverdell Education Savings Accounts (ESAs): ESAs are tax advantaged accounts used to save for K-12 education expenses. Just like the 529 plan, contributions made into these accounts are not tax-deductible until withdrawn. One limitation is that withdrawals from an ESA must go towards qualified educational expenses. In addition, they cannot exceed $2000 per year, or you will have taxes withheld at your income’s marginal rate plus a ten percent penalty (this includes early withdrawal penalties).
- Simplified Employee Pension or SEP IRAs: A SEP plan is a retirement savings vehicle that allows self-employed individuals to contribute to their future financial security on a tax-deferred basis. Contributions are limited, but the money can be invested in any way you choose and grow tax-free until you withdraw at retirement age. SEPs may also be established as part of an employer-provided benefits package or by yourself without your company’s knowledge.
Benefits of Tax Advantaged (TAD) Accounts
Below are some of the benefits of TAD accounts:
- Tax advantaged accounts are a great way to save on taxes. The higher the income, the more money you’ll be saving in taxes by putting your money into these types of investment vehicles. In addition, you can enjoy tax deductions and credits that could lower or eliminate some capital gains depending on how long it’s been held for and if it is considered qualified. This makes investing with an account such as this one even more worthwhile because you’re not only getting access to tax benefits but also inside your investments themselves!
- Having funds saved up for retirement means relying less heavily on social security, which has its own set of rules about what happens once those funds run out. And while there have been recent changes to the social security plans, it’s always better to take things into your own hands. Tax advantaged accounts make that possible, with many of them offering tax deductions and credits when you withdraw funds from their investments for retirement purposes.
In addition to these benefits, there are some other things to keep in mind when choosing an account for tax advantaged savings:
- The goal of investing should be retirement, so don’t invest funds that will eventually need to go into another type of investment like real estate or business ownership.
- What age does my child have? If your child is not yet 18 years old, then it’s best if you open up a custodial IRA with them (another form of saving).
- How much money does my child need? If your child needs to use the funds for something other than a college education, then it’s best if you open one up instead of opening an IRA with them.
Tax advantaged accounts are a great way to invest for the long term. They offer tremendous advantages, including tax benefits and diversification without sacrificing liquidity or having to worry about investment fees.
