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What are tax-advantaged accounts?

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What are tax-advantaged accounts?

If you’re looking to invest, you are probably wondering what are tax-advantaged accounts? What makes them advantageous compared to other investments? What’s the difference?

These are great questions! Understanding which accounts are tax-advantaged will help you make an informed decision and enhance your wealth accumulation. Let’s discuss the differences and advantages of tax-advantaged accounts. 

Tax-advantaged Accounts

 The accounts listed below are the most common and widely used tax-advantaged accounts:

The biggest difference between taxable and tax-advantaged accounts – earnings on investments aren’t taxed year after year. Accounts such as 401(k)s and Traditional IRAs are taxed during retirement when the time comes to start taking withdrawals. Roth IRA and Roth 401(k) contributions are initially taxed but withdrawals are tax-free.

There are differences among tax-advantaged accounts which I will discuss later in detail. 

Taxable accounts, on the other hand, you’re required to pay capital gains taxes any year you realize a gain. A realized gain results from selling an asset at a price higher than the original purchase price. An example: you buy Apple stock at $100 per share and sell it when it hits $120 after six months. Capitals gains tax varies on how long you held the stock and your taxable income.

There are ways to mitigate capital gains tax on taxable accounts, but I will discuss that in another article. 

Differences and Advantages

The tax-advantaged accounts I listed earlier fall into two categories – tax-exempt and tax-deferred. So when you hear or read about tax-advantaged accounts, they’re referring to these.

Tax-deferred accounts include:

Tax-exempt accounts include:

The differences between the two categories have immediate and future tax implications that must be considered.

Tax-deferred

Tax-deferred means that you don’t pay income taxes on contributions. But once you reach retirement age, taxes are assessed when funds are withdrawn.  In other words, you’re able to defer taxes until retirement.

The best way to understand the benefits of tax-deferred investing is to compare it to taxable investing. When you invest in a taxable account, you typically pay tax at three different levels:

  1. You pay income tax on your contributions
  2. You pay tax on dividends received in your account
  3. You pay tax on capital gains realized after selling assets at a gain

But in a tax-deferred account, you avoid two of three levels of taxation:

  1. You get an income tax deduction on contributions
  2. Your contributions grow tax-free while they’re in the account (no tax on dividends or capital gains)
  3. You pay income tax only when you take withdrawals from the account later on

Tax-exempt

Tax-exempt investing is the opposite of tax-deferred investing.  Rather than pay tax on the withdrawals from your retirement account, a tax-exempt account requires you to pay income tax on your contributions. These contributions then grow tax-free compounding over time, and your withdrawals can be taken tax-free once you reach retirement age.  

Rather than paying tax on the “back end” in a tax-deferred account, you pay tax on the “front end” in tax-exempt accounts.

Tax Implications

Where do you fall into the tax bracket? This must be considered when you select a tax-advantaged account. Why? Depending on your current tax liabilities and where you think you might fall in retirement, you must decide whether to pay them now or later. Either way, you’re paying tax, however, you can decide when.

2019 tax bracket 

There’s always a debate whether it’s better to take the tax deduction now by contributing to a traditional IRA or pay taxes immediately by contributing to a Roth. Let’s look at some examples of why this is a debate and how it varies for each individual. 

Tax Examples

If you’re in the middle of your career and enjoying your peak earning years, it’s likely you’re in a higher bracket now than you’ll be after you retire.  And if that’s the case, taking the “exempt” route in a traditional IRA would be the most beneficial as seen in the example below.

tax ira example

But, if you expect your tax burden to be higher during your withdrawal period than it is now, the deferred method favors “getting the tax out of the way” now.  You could easily find yourself in this situation earlier on in your career, or maybe following a career change when your income is lower.

tax roth ira example

If you’re unsure which tax bracket you will fall into in the future, don’t worry. You can always switch your contributions around once you find out. If you think you will fall into the same tax bracket in the future, then it doesn’t matter as seen below.

equal tax brackets

One thing to note in the example above is the column for “taxable account.” There is a major difference between taxable and tax-advantaged accounts when you withdraw. It’s important to use tax-advantaged accounts when you invest and should always max them out prior to investing in taxable accounts. 

Conclusion

While traditional IRAs and 401(k)s do come with certain limitations — namely, the fact that you’ll incur a penalty for withdrawing your money before age 59 1/2 — the growth opportunities they offer are more than enough to compensate.

Currently, workers under 50 can contribute up to $6,000 a year to an IRA, and $19,500 a year to a 401(k). If you’re 50 or older, you get a catch-up provision that raises these limits to $7,000 and $26,000, respectively. Find out all the 2020 Retirement limits.

Maxing out either option will give you a chance to amass a sizable nest egg that will serve you well in retirement, and the sooner you begin saving, the more you’ll benefit from that tax-advantaged growth.

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