Tax-advantaged accounts are an integral part of any successful retirement financial planning. Today’s article explains what tax-advantaged accounts are and more importantly, it shares seven tax-advantaged accounts that can help you maximize your retirement savings.
In this article:
- What Are Tax-Advantaged Investments and Plans?
- Tax-Deferred vs Tax-Free Retirement Accounts
- Tax-Advantaged Retirement Accounts
Tax-Advantaged Accounts: 7 Plans to Leverage Your Retirement Now
What Are Tax-Advantaged Investments and Plans?
Tax-advantaged investments are financial investments or plans that enjoy tax benefits like tax exemption and tax deferral.
- Municipal bonds are examples of tax-advantaged investments.
- Qualified retirement plans like IRAs and 401(k)s are examples of tax-advantaged plans or investment accounts.
For purposes of this article, we’ll focus on tax-advantaged qualified retirement plans.
Tax-Deferred vs Tax-Free Retirement Accounts
There are two kinds of tax-advantaged, qualified retirement accounts: tax-free savings and tax-deferred savings accounts.
Tax-Free Savings Accounts
People who are preparing for retirement will experience the tax benefits of these types of qualified retirement accounts when they make distributions later on. Qualified distributions from tax-free retirement accounts, such as those after turning 59 ½ years old, are neither taxed nor penalized.
There aren’t any taxes because income that funds contributions to a tax-free retirement plan is considered after-tax. This means that the IRS has already taxed the income from which such contributions come from.
The tradeoff for paying taxes now rather than later is tax-free capital gains. In short, those who are preparing for retirement won’t pay taxes on qualified distributions of investment gains made under a tax-free qualified retirement plan.
Examples of tax-free retirement savings plans are Roth IRAs and Roth 401(k)s.
Tax-Deferred Retirement Savings Accounts
Unlike a tax-free retirement, whose tax benefits come later, a tax deferred retirement savings account gives tax benefits now. Its primary tax advantage is the fact that individuals can use contributions to this kind of plan as a legitimate income tax deduction on their tax returns.
The tradeoff for enjoying tax savings now is paying regular income taxes on distributions or withdrawals in the future. If an individual’s income tax rate goes up in the future, he or she may end up paying more taxes.
Traditional IRAs and 401(k) plans fall under this category.
Tax-Advantaged Retirement Accounts
1. Traditional 401(k)
This traditional employer-sponsored, tax-deferred qualified retirement plan is probably the most popular among those preparing for retirement for several reasons. Aside from the tax advantage they can enjoy now, it also allows them to put more money into it.
For example, the 2019 maximum annual contribution limit for IRAs is only $6,000, with $1,000 extra for catch-ups. For traditional 401(k)s, the annual limit is $19,000, with an additional $6,000 allowed for catch-up contributions.
With traditional 401(k) plans, individuals need to be particular of fund expense ratios and third-party fees, such as 12b-1 fees. These can affect the returns on your retirement investments under this plan.
2. Solo 401(k)
This plan is the solopreneurs’ alternative to the employer-sponsored, traditional 401(k). In particular, the solo 401(k) is great for solopreneurs who earn a lot and want to maximize their tax savings.
Like with a traditional 401(k), the maximum tax-deductible annual contribution limit for 2019 is $19,000. As with a traditional 401(k), solopreneurs can put in an additional $6,000 annually, too, for qualified catch-up contributions.
Also, this type of 401(k) plan allows solopreneurs to contribute from their business’ before-tax profits up to 25% of compensation. This means that on top of the solopreneurs maximum personal contribution of up to $25,000 (including catch-ups), the business can contribute to the owners’ solo 401(k) up to 25% of compensation!
3. 457 Plans
This type of tax-advantaged investing plan is very similar to a 401(k). However, there are two major differences between a 457 plan and a 401(k) one.
The first difference involves early withdrawals from the retirement account. Individuals who withdraw funds early won’t pay a 10% penalty unlike with a 401(k)s but instead, they’ll pay income taxes.
The second difference is that 457 plans are available to specific local and state government employees only. The 401(k) is available to all employees.
A 457 plan, when available, effectively doubles an individual’s employer-sponsored tax-advantaged investing limit. If their employers offer both plans, they can contribute up to $25,000 (including catch-ups) annually to each account.
4. Traditional IRAs
This type of tax-advantaged investment account is similar to a traditional 401(k) in that it’s also tax-deferred, but the similarities end there.
Traditional IRAs, unlike traditional 401(k)s, aren’t sponsored by employers. This means both employees and entrepreneurs can contribute to Traditional IRAs.
However, Traditional IRAs limit the people who can contribute to those who are below a specific annual income level. The following are total income contribution limits for both Traditional and Roth IRAs:
|Tax Filing Status||Modified AGI||Maximum Annual Contribution|
|Married and Filing Jointly OR Qualifying Widow/Widower||Below $193,000||
|Between $193,000 and $202,999.99||Less than the maximum annual contribution|
|$300,000 and more||Ineligible to contribute|
|Single, Head Of Household, OR Married Filing Separately (and not living with a spouse during the taxable year)||Less than $122,000||
|Between $122,000 and $136,999.99||Less than the maximum annual contribution|
|$137,000.00 and higher||Ineligible to contribute|
|Married, filing separately, and lived with a spouse during the year||Less than $10,000||Less than the maximum annual contribution|
|$10,000 or more||Ineligible to contribute|
However, a Traditional IRA has more investment options than 401(k)s, which appeals to more seasoned investors. Hence, the Traditional IRA is often used to complement a 401(k) plan, especially when the latter’s already maxed out.
5. Roth IRA
While both Roth and Traditional IRAs share the same income and total contribution limits, they’re different in two major ways.
- A Roth IRA is a tax-free savings account. Since after-tax income funds Roth IRA contributions, future qualified withdrawals on both contributed amounts and investment gains are already tax-free.
- The second major difference is retirement investment options. A Roth IRA covers many different types of investments, including cryptocurrencies and real estate, unlike a Traditional IRA that only covers plain vanilla investments like stocks, bonds, and mutual funds.
A special feature of Roth IRAs, one that allows individuals to bypass the annual contribution limit, is the “backdoor.” Backdoor Roth IRAs involve backdoor contributions, such as rolling over money or investment from Traditional IRAs to Roth IRAs.
6. Self-Directed IRA
A self-directed IRA is one where the individual has complete control over the kinds of assets they want to invest in. Unlike Traditional and Roth IRAs, which are managed by professional managers, individuals manage their self-directed IRA investments by giving their IRA custodians instructions on where to put their money.
With self-directed IRAs, investors can put their investment and money in higher-risk, higher-return potential assets like cryptocurrencies, precious metals, real estate, and limited liability corporations (LLCs). But with most managed Traditional and Roth IRAs, individuals can’t invest in these.
Investing in this type of IRA requires opening an account with a specialized custodian. The custodian gets investment instructions from you that the custodian will carry out.
7. Health Savings Account
HSAs, or health savings accounts, help those preparing for retirement plan for and fund their retirement medical expenses via tax-advantaged accounts. Without proper planning and allocation, health-related issues can cause major dents on any retirees’ finances.
HSAs may be considered a hybrid tax advantage account. This is because individuals can use contributions as tax deductions (tax deferred). They then use it later on to pay for qualified medical expenses tax-free.
Those who want to continue growing their health savings accounts investments can do so by paying for them out of personal funds first. After a few years of investment growth, they can reimburse qualified medical expenses paid with their own money – tax-free – for as long they have supporting documents like official receipts.
Individuals who withdraw their investment or money from health savings accounts for non-medical or unqualified medical expenses will pay regular income tax on the withdrawal. Hence, they need to ensure HSA withdrawals are for legitimate and qualified medical expenses only.
Tax-advantaged accounts are crucial for ensuring that one’s golden years are truly golden and stress-free. Hence, you should know your retirement goals, plan your retirement strategy, and choose your tax-advantaged accounts based on your goals and strategy.
Of these seven tax-advantaged accounts, which do you think is best for you, given your retirement goals and strategy? Share your thoughts with us in the comments section below!