Putting aside enough money to pay for big goals like college and retirement isn’t easy. Tax-advantaged accounts are Uncle Sam’s way to give savers a head start.
The best known tax-advantaged account is the 401(k), which Congress created back in 1978, but there are now lots of other accounts offering tax benefits—from Health Savings Accounts for healthcare to 529 college savings plans for education, plus a number of other retirement options.
Congress hopes tax breaks attached to these accounts will encourage you to set aside and invest money for the long term. While the mechanics vary, many accounts allow you to defer income taxes on money you contribute—and taxes on investment income such as capital gains and dividends may also be deferred or entirely waived.
Tax-advantaged accounts can be especially critical for retirement savers. After all, people generally can’t count on programs like Social Security and Medicare to take care of all their needs, according to Dave Alison, founding partner of Prosperity Capital Advisors in Westlake, Ohio. “Those quite frankly aren’t enough to cover the income gap that most retirees will have,” he says.
Read on to see the differences between the two main varieties of tax-advantaged accounts, and the distinctions between particular tax-advantaged retirement, healthcare and education accounts. At the bottom you will also find a refresher on how taxes are ordinarily taxed.
Types of Tax-Advantaged Accounts
Most tax-advantaged accounts lower your taxes in one of two ways.
- Tax-deferred accounts: These include 401(k) and traditional IRAs and offer tax savings when you contribute to the account. You’re then on the hook when you take money out.
- Tax-exempt accounts: These include so-called Roth 401(k)s and IRAs as well as 529s. You contribute after-tax dollars to these accounts, but afterward you may be able to spend it tax-free.
Which is better? Obviously the choice can be complicated. But experts say that in general, you want to pay taxes whenever your rate is lowest. If you are just starting out in your career and haven’t reached your top salary, it may make sense to pay taxes now. If you are in your peak earnings years, it could be worth it to gamble you’ll be in a lower tax bracket when you hit retirement.
Tax-Advantaged Retirement Accounts
If you’re like most people, you haven’t saved as much as you expect to need in retirement. One recent study by Northwestern Mutual found Americans would like to save as much as $1.3 million before they stop working, while those in their 40s actually have less than $80,000 on average. Keeping your money in a tax-advantaged retirement account can help you stretch what you do sock away.
Traditional 401(k)
You’ve probably heard of 401(k)s. Since their creation in 1978, they’ve become a mainstay of the American retirement system, with nearly $7 trillion in assets. More than a third of workers have a 401(k) or a similar plan. And the plans work: More than 375,000 savers have managed to use a 401(k) to accumulate $1 million or more.
Traditional 401(k)s are tax-deferred accounts, so you contribute to them with pretax money. Your contributions and investment gains are then taxed at income-tax rates when you withdraw them in retirement.
A 401(k) typically also offers some benefits that aren’t tax-related, according to Pam Lucina, chief fiduciary officer at Northern Trust. Among the best of these: Employers frequently kick in some extra money in what’s known as a 401(k) match. Matches vary, but on average employers match 4.5% of workers’ salaries and some even go up to 7% or more, according to a study by Vanguard. And your contributions are automatically deducted from your paycheck. “It makes you consistent,” she says. “You don’t even have to think about it.”
To sign up for a 401(k), you give your employer permission to deposit part of your salary directly into the account, often housed at a large investment firm like Fidelity, Vanguard or Principal. Then you get to choose from a menu of investments, usually mutual funds.
The IRS limits how much you can add to 401(k)s each year, although you can make additional “catch up” contributions if you’re age 50 or older. In 2023, you can put in up to $22,500 if you’re under 50 and an extra $7,500 if you’re older and making catch-up contributions. There are limits on employer contributions, too.
The IRS doesn’t want wealthy people using 401(k)s to avoid taxes forever, so you have to start pulling money out in “required minimum distributions” when you turn 73.
While 401(k) can be great for retirement saving, be careful you don’t tie up money you might need before you reach retirement age. Unless you qualify for an exception, you’ll be hit with a 10% additional tax if you withdraw money before age 59½.
It’s painful to see clients have to dip into their 401(k)s and pay that penalty, says Jeffery Wood, partner at Lift Financial in South Jordan, Utah. “It hurts me. I feel it deep inside when they’re pulling money from them,” he says, “because I know you can only fund them with so much, and there’s limits. And it’s really taking a bite out of their retirement.”
Roth 401(k)
Not everyone is thrilled with paying taxes on 401(k) income in retirement, especially if they’re taking out a lot of cash at once to buy something big like a summer home or a sailboat. So for those who want to pay taxes now and enjoy more tax-free money in their golden years, there’s the Roth 401(k), introduced in 2006.
Roth 401(k)s are similar to traditional plans, except that you make contributions with income you’ve already paid taxes on, and you don’t get taxed on distributions as long as you follow the rules. That means you typically have to wait until you’re 59½ to pull money out, unless you become disabled.
The $22,500 contribution limit applies to traditional and Roth 401(k)s combined, so you can max out your contributions to either one by itself or split your contributions between the two account types.
Roth 401(k)s will soon have an additional advantage over traditional plans. For 2023, both accounts require you to start pulling money out once you turn 73. But starting in 2024, the IRS will no longer mandate these distributions from Roth 401(k)s, so you’ll be able to enjoy compounding returns further into the future. It doesn’t really matter to the IRS whether you take everything out in your 70s or leave it in for another 20 years, because they’re not getting a cut of the distributions either way.
Traditional IRA
You might not work for a company that offers a 401(k), or maybe you want an account that you can contribute to throughout your career—even if you switch jobs or start your own business. The IRA offers a way to save without being tied to an employer. Americans have $12.5 trillion in assets in IRAs, almost twice the value in 401(k)s, and more than 31% of households have a traditional IRA.
You can set up an IRA yourself through a bank, mutual fund, stockbroker or life insurance company. You choose from a variety of investments that the financial institution offers, and those options can go far beyond the mutual funds you typically buy in a 401(k). You can often buy stocks, bonds, ETFs and annuities, and you might even get to pick alternatives like real estate or gold.
A traditional IRA is tax-deferred, but not everyone gets the tax deduction. The government wants to cap deductions for high earners. Therefore, if you have a 401(k) or similar retirement plan at work, income limits for tax-deferred contributions start to kick in at $73,000 for a single person. And different limits apply if you’re married and your spouse has a plan through work.
In 2023, the maximum you can contribute to an IRA (or all your IRAs if you have more than one) is $6,500, or $7,500 if you’re 50 or older. You can also move money from an employer-sponsored account like a 401(k) into your IRA, which is called a rollover. It’s a popular move when you leave a job, which allows you to keep all your retirement savings in one place as you move from company to company throughout your career. The IRS contribution limits don’t apply to money you roll over into an IRA, but only certain accounts can be rolled over and there are some restrictions on when you can roll over accounts.
You can take savings out of an IRA before your retirement if you need to, but just like with a 401(k), you typically pay a 10% additional tax penalty on money you withdraw before age 59½ unless one of a few exceptions applies. An IRA is more flexible with exceptions than a 401(k) and lets you dip in early if you’re using the money to pay health insurance premiums when you’re unemployed, pay college tuition or buy your first home.
And as with other tax-deferred accounts, you can’t leave your investments in there to grow indefinitely. In 2023, you must begin taking required minimum distributions from the account when you turn 73.
Roth IRA
A Roth IRA is the tax-exempt counterpart to a traditional IRA that was introduced in 1997 and has since become widely popular. They are now owned by nearly 1 in 4 American households.
With a Roth IRA, you contribute money that’s already been taxed, but you don’t pay any taxes when you withdraw the money later on. You have to keep your investments in the account until you’re 59½ to get the full tax benefits. If you dip into the earnings early, you’ll owe income taxes on any capital gains and dividends you’re taking out. And if you aren’t using the money for an approved exception, you’ll owe the 10% additional penalty on the withdrawal.
But Roth IRAs have one great feature other retirement accounts lack: You can take out the money you contributed (but not your investment earnings) whenever you want, and you won’t get hit with a penalty. That makes a Roth IRA much more flexible than the traditional account, especially for your young investors who aren’t committed to tying their savings for decades to come.
The catch? Not everyone gets to contribute to a Roth IRA. Your modified AGI must be under $138,000 if you’re single or head of household and under $218,000 if you’re married and filing jointly, to make the maximum contribution. Still, if your income is slightly above the limits, you might be eligible to contribute lower amounts. “Even though they would love to save in a Roth, I do have some clients that it’s just not possible,” Wood says.
A “backdoor” Roth IRA conversion offers a workaround for high earners. Someone who has too much income to contribute to a Roth IRA directly can contribute after-tax earnings to a traditional IRA, then convert it to a Roth. The tax implications of doing this can be complex, so you’ll want to figure out if the cost is worth it for you before going this route.
Tax-advantaged healthcare accounts
Healthcare adds up to $4.3 trillion in annual spending in the U.S., and even if you’ve got good insurance, you can expect to pay some of that out of pocket. On average, people who have health insurance through work have to shell out nearly $1,800 a year before insurance pays. Even with Medicare, older adults may need more than $150,000 to cover their out-of-pocket health costs in retirement.
So it makes sense to get a head start and save up in a healthcare account. Depending on the account you select, you can use a tax-advantaged account either to prepare for medical expenses in the future or to set aside money for your health needs this year.
HSAs
Health Savings Accounts are like 401(k)s for health expenses—except they have even bigger tax advantages. They were introduced in 2003, then expanded under the Affordable Care Act to help Americans cope with spiraling healthcare costs. Americans have nearly 36 million HSAs, and that could grow to 43 million by the end of 2025, according to a study by Devenir.
Financial planners love HSAs because they offer a triple tax advantage: You put money into them pretax, your investments grow tax-free, and you don’t pay any taxes on qualified withdrawals for things like doctor’s visits, prescription drugs and supplies like Band-Aids. “Health savings accounts are the star of the show, as far as tax-advantaged accounts go,” says Marla Chambers, a financial planner with Buckingham Advisors in Dayton, Ohio.
To contribute to an HSA, you need to be covered by a high-deductible health insurance plan, meaning a plan with a deductible of at least $1,500 for an individual or $3,000 for a family. So an HSA is an option only if you accept some unpredictability in your out-of-pocket expenses.
As of 2023, the contribution limits are $3,850 if your health insurance covers you by yourself, or $7,750 if you have a family insurance plan. If you’re 55 or older, you can put in an extra $1,000 per year in catch-up contributions.
If you’re under age 65, you can withdraw your savings to pay out-of-pocket bills for medical care you received since you set up the account. Taking money out for other purposes means you owe income taxes on it, plus a steep 20% penalty.
What happens if you’re healthy and you don’t need all the money for its intended purpose? Starting at age 65, you can use your HSA like any other tax-deferred account. You can withdraw savings for any reason penalty-free, and you’ll just pay income tax on anything that doesn’t go to eligible medical bills.
FSAs
If you don’t want a high-deductible plan, a Flexible Spending Account through your employer might be a good alternative. You can put in up to $3,050 of your earnings per year before taxes, and you get reimbursed by the account for a variety of medical costs including copays, deductibles and prescription drugs.
A big drawback of an FSA is that if you don’t use the money, it goes back to the employer when the year is over. Your employer might give you an additional 2 1/2 months of the following year to keep spending with it, or it could let you carry over $610 of your money. But after that, it’s gone. “You really have to be able to forecast what your medical expenses will be,” Lucina says.
Tax-advantaged education accounts
Students usually borrow about $8,000 a year to attend public four-year colleges and more than $9,000 a year for private colleges. If you’d like to help a student keep their loan balance low, it makes sense to start saving in an education account.
529 college savings plans
A 529 college savings plan is an education savings vehicle that’s tax-exempt, similar to a Roth account. In other words, you contribute after-tax dollars, but then the money grows tax-free and you spend it tax-free—as long as you’re pulling money out for college tuition, student loans, other higher education expenses or up to $10,000 a year in K-12 expenses.
One thing that’s different about 529 plans is that they’re sponsored by states. Some states offer additional tax breaks when you contribute.
If the student you’re saving for ends up not needing all the money for school, you can roll over the account for a sibling or another close family member. That might be preferable to withdrawing money for something other than education, because in that case the beneficiary has to pay tax on the gains in the account plus a 10% federal tax penalty.
Moving money out of this account will be less expensive starting in 2024, when beneficiaries of 529 plans will be allowed to roll over up to $35,000 during their lifetime from a 529 to a Roth IRA. There are some restrictions, such as that the 529 account has to be set up at least 15 years previously and the money has to stay in the account for at least five years first. But with this new option, “there’s more flexibility than there ever has been around mitigating the impact of overfunding a 529 plan,” Lucina says.
Coverdell ESAs
A Coverdell Education Savings Account is a trust account that you can use to save for a child’s education. Like a 529, it’s built on the Roth model: You contribute after-tax dollars, and earnings and qualified withdrawals are tax-exempt. You can use it for K-12 education expenses or for college.
A child can have multiple Coverdell ESAs, but the total contributions to all their accounts can’t go over $2,000 in a year, so this account doesn’t let you save up as much as most 529 plans. And eligibility to contribute to a Coverdell ESA starts to phase out when your modified AGI is $95,000 if you’re single or $190,000 if you’re filing jointly.
How investments are ordinarily taxed
If you buy a taxable investment through a brokerage account, you pay for it with income that you owe income taxes on. And you typically have to pay taxes on your investment when it generates income or when you sell it.
Taxes on interest income
When you lend someone money, you expect to earn interest. Naturally, Uncle Sam wants a cut.
Interest that you earn on investments like money-market accounts, CDs and corporate bonds is typically taxed at your usual income-tax rate, which could be as high as 37% if you’re in the top bracket. It makes no difference if you earn that interest directly or if it gets paid out through a dividend—such as when a mutual fund or ETF passes along interest from bonds. Either way, you’re on the hook to pay that income-tax rate.
But on the bright side, you don’t have to pay federal taxes on certain tax-advantaged investments like municipal bonds.
Taxes on capital gains
Selling an investment at a profit means you have a capital gain, which you might owe taxes on. You’re taxed on the amount you receive when you sell a stock or bond minus the price you paid, which is called the cost basis.
Congress wants people to invest their money to grow the economy, so it set long-term capital-gains rates below income-tax rates. If you hold on to an investment for longer than a year before selling it, you’re usually taxed at either 0%, 15% or 20%. (Short-term capital gains get taxed at income-tax rates because when you turn around and sell an investment that fast, the tax code figures you’re a middleman, not an investor.)
Taxes on dividends
How dividends are taxed depends on their status. If you own blue-chip stocks you will mostly receive qualified dividends. (These are issued by U.S. stocks and most major foreign stocks you have held for at least 61 days.) The good news: these are taxed at the generally lower capital-gains rates.
Not all dividends qualify, though. If you own stock in a foreign company whose country doesn’t have a tax agreement with the U.S. or if a stock is new to your portfolio, you’re stuck paying the higher income-tax rate.
Net investment income tax
High-income investors face another tax on top of the others. This tax, known as the Net Investment Income Tax, applies to your income on investments, including dividends and capital gains, and kicks in if your modified adjusted gross income, or AGI, is above $200,000 for a single taxpayer or head of household, $125,000 for a married taxpayer filing separately and $250,000 for married taxpayers filing jointly.
The Net Investment Income Tax rate is 3.8%, and you pay it on investment income minus certain expenses such as brokerage fees.
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Sarah Brodsky
Sarah Brodsky is a contributor to Buy Side from WSJ.
