What Is a Tax-Advantaged Account?
A tax-advantaged account is a financial account with tax benefits that is designed to help you save for important financial milestones and purchases like retirement, college, and medical expenses.
Tax-advantaged accounts typically fall into two categories: tax-deferred and tax-exempt accounts.
Tax-deferred accounts, also known as pre-tax accounts, will not tax money that is deposited into the account. However, the money is taxed when you withdraw it, making the taxes “deferred” until you use them.
Tax-exempt accounts, also known as after-tax accounts, do not have tax breaks when the funds are deposited, but you can withdraw funds tax-free if you follow the rules of the account. By paying the taxes up front, you won’t pay when you withdraw.
Both types of accounts have their advantages and disadvantages, so having a combination of tax-deferred and tax-exempt accounts can set you up with several tax benefits.
Types of Tax-Advantaged Accounts
Retirement Plans
One of the most common tax-advantaged accounts is a retirement account. These accounts are typically sponsored by an employer, but you can also open some as an individual.
401(k): This is one of the most well-known types of retirement plans. A 401(k) is an employer-sponsored plan that is funded by employee and employer contributions. These funds are typically a percentage of the employee’s paycheck with the employer matching an equivalent percentage.
403(b) & 457(b): These accounts are similar to a 401(k) with an employee contributing with an employer matching a percentage. The 403(b) accounts are used by non-profit employees while 457(b) accounts are used for state and municipal employees.
IRA: IRA accounts are a good choice for self-employed individuals or those who have maxed out their contributions to other retirement accounts and want to keep contributing. The tax advantages depend on if you choose a traditional or Roth IRA. A traditional IRA is a tax-deferred account while a Roth IRA is a tax-exempt account.
Education Plans
If you want to save for a child or family member’s education, there are tax-advantaged accounts you can use to make saving easier.
529 College Savings Plan: States usually sponsor 529 plans and allow you to contribute pre-tax income and withdraw it tax-free to pay for qualifying educational expenses.
If you have money left over, you have options to control the funds, such as by rolling over the funds into a Roth IRA in the beneficiary’s name.
Coverdell Education Savings Account: Similarly to a 529, you can contribute to a Coverdell ESA pre-tax and withdraw tax-free for educational expenses. One of the main perks is that it can be used for educational expenses outside of college, such as K-12 education. However, you are more limited in the amount you can contribute.
Health Plans
Medical expenses can be costly if you’re not prepared for them. With health savings plans, you can budget for these expenses, making them a little easier to pay when they come around.
HSA: If you have a high-deductible health plan, you can use an HSA to save for larger out-of-pocket expenses. Your contributions are pre-tax and withdrawals for qualifying expenses are tax-exempt, giving you lots of tax benefits. Your employer may contribute to your HSA, too.
These plans are set up by individuals and are not tied to your employer, but you do need to have a high-deductible health plan to qualify. The funds also roll over to the next year without a spending requirement.
FSA: Like HSAs, FSAs allow you to contribute pre-tax and withdraw tax-free for qualified medical expenses. However, you can only get this type of account through your employer and you can lose the funds if they’re not spent.
Your Tax Strategy With Tax-Advantaged Accounts
Tax laws can change from year to year, with some years changing more than others. That’s why it’s important to have a knowledgeable tax preparer who can handle your unique situation and advise you on which accounts work for your financial goals.
The friendly and knowledgeable staff at AMG Finance can help you accurately include tax-advantaged accounts on your tax return with our tax preparation services.
Visit a local branch to get started or learn more about how tax-advantaged accounts can work for you.
