When it comes to paying taxes, we get it: it can be frustrating to seemingly lose so much of your hard-earned dollars. While there may not be a legal way to avoid paying taxes, there are great ways you can invest in your future and minimize your tax exposure at the same time. Seem like a win-win? We think so, too!
What exactly is a tax-advantaged account?
Tax-advantaged accounts are certain types of investment, savings, or financial accounts that provide you with the great benefit of tax-exemption or tax-deferral.
These types of accounts can be broken down further into two types:
- Pre-tax accounts. Pre-tax accounts are those that allow you to contribute pre-tax money to the account, with the intention of letting the account grow and appreciate before paying any taxes. These taxes then are “deferred” to much later on.
- After-tax accounts. After-tax accounts are those that allow you to contribute money that has already been taxed. The major benefit here is that you already paid taxes on the funds you contributed, so you won’t have to pay taxes later on when you withdraw the funds. This can save you substantially, particularly if you anticipate that your tax bracket might be higher later in the life (and therefore, your tax liability!).
There are many rules and restrictions governing these types of accounts, but they’re helpful tools individuals can use to strategically plan for their tax situation. The most common types of tax-advantaged accounts are retirement accounts.
Pre-Tax accounts that you’ve likely heard of include most employer-sponsored retirement plans such as the 401(k), 403(b), 457 plan, and the Traditional IRA. Though each of these types of plans has their various contribution limits and restrictions, they all allow you to contribute money pre-tax to these accounts so that you don’t have to pay the taxes on the account until retirement age. This can be especially beneficial because, in most cases, the amount you contribute to these accounts can often be deducted from your total taxable income (which will lessen your tax burden for the current year, too!).
Many individuals use these retirement accounts because they allow you to save a substantial amount for retirement, which will grow tax-free for years prior to you having to withdraw the funds at retirement age. Imagine letting the funds in your account benefit from compound interest without interruptions each year to subtract for taxes! This is a huge way to let those hard-earned dollars work even harder for you.
On the other hand, if you’d prefer to save for retirement but tackle your tax responsibilities now, you can open any of these types of after-tax accounts: Roth IRA, Roth 401(k), Roth 403(b), or a Roth 457.
These types of plans are similar to their non-Roth pre-tax versions, but they do require you to make your contributions with money that has already been taxed. The other big thing to consider? The contributions you make to these accounts cannot be deducted from your taxes, meaning they do not lessen your overall taxable income for you.
So…how do I know what type of account is right for me?
When deciding which type of account to open, there are a few things to consider:
- Do you anticipate your income will increase over time (which would increase your tax bracket at retirement age)? If so, it may make sense to open an after-tax account so that you can take care of your tax obligations now!
- Does your employer offer a match on retirement plan contributions? If so, it is wise to contribute at least enough to your employer-sponsored plan (such as a 401k), in order to take advantage of their matching contribution. Free money is always welcome!
- Do you qualify for an after-tax account? While there are no income restrictions on a Roth 401(k), 403(b) or 457 plan, there ARE restrictions on a standard Roth IRA. To see if you’re eligible to open one of these accounts, view the income limitations here!
- Do you need to lessen your tax burden as much as possible at the present moment? If the answer is “yes”, then perhaps you do need to ensure you’re contributing to a pre-tax account so that deducting your contribution and lessening your tax obligation is a possibility.
- You can open both! It’s true! You might make a sound choice to spread your risk across both different types of tax-advantaged accounts. In this case, you might choose to contribute to both a work-place retirement plan (such as a 401(k)) AND a Roth IRA (if you’re eligible). You might also be able to open and contribute to both types of IRA: Traditional and Roth (yet, be mindful that regardless of having both accounts, you can only contribute up to $6,000 total per year between the two accounts; up to $7,000 total if you are at least age 50 by the end of the year).
Ultimately, the choice you make depends on your current income and tax situation, your ability to open and contribute to a Roth IRA, and whether or not you prefer to pay taxes now or at retirement age. If you’re not sure what option to choose, your financial advisor is a great person to consult with for guidance.
Other tax-advantaged accounts you’ll want to know about:
Flexible Spending Accounts (FSAs): These tax-advantaged accounts are employer-sponsored plans that allow you to contribute tax-deferred funds for certain eligible purposes, such as health or dependent care needs. However, make sure you use any of the funds you contribute because if you don’t, they typically can’t be rolled over for use in the next year. *To learn more about FSAs and to see if your employer offers this type of plan, reach out to your benefits department.
Health Savings Accounts (HSAs): These tax-advantaged accounts allow your contributed funds to grow tax-free, and withdrawals are also tax-free if you use the funds for health-related expenses. These funds are only available to those with high-deductible health insurance plans, but if you are eligible for one, they can be great tax-efficient ways to save money for your health needs. Another perk? The funds you contribute each year can be rolled over from year to year (meaning you won’t “lose them” if you don’t “use them” that that given year). Finally, once you reach the age of 65, the funds can be used for non-health related expenses. *To open this type of plan, contact your employer’s benefits department or consider opening one at a financial institution such as FirstDollar.
College Savings Plans: Educational Savings Plans, such as 529 plans or Coverdell Education Savings Accounts, are great ways to contribute after-tax dollars for educational purposes. These contributions then grow tax-deferred and withdrawals can be made tax-free as long as the funds are used for qualifying educational purposes. *For more on these types of educational funding options, talk to your advisor!
This post is sponsored by H&R Block and may contain affiliate links. We’d like to thank them for their partnership and dedication to helping educate women on their retirement options and empower them to own their financial futures.
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