Tax-Advantaged Accounts: Maximize Your Savings and Reduce Taxes

What Is Tax-Advantaged?

Tax-advantaged investments and accounts provide significant tax benefits, allowing you to grow your wealth while minimizing your tax burden. These financial opportunities come in two primary forms: tax-deferred and tax-exempt.

Tax-deferred accounts, like traditional IRAs and 401(k) plans, let you delay taxes on earnings until withdrawal, whereas tax-exempt accounts, like Roth IRAs, allow for tax-free growth and withdrawals after retirement. Understanding the distinctions between these accounts helps tailor your investment strategy to your financial situation, providing long-term tax benefits.

 How Tax-Advantaged Accounts Work

Tax-advantaged investments and accounts are used by a wide variety of investors and employees in various financial situations. High-income taxpayers seek tax-free municipal-bond income, while employees save for retirement with IRAs and employer-sponsored retirement plans.

The main strategies to lower tax bills are tax-deferred and tax-exempt statuses. Choosing which one, or both, depends on when you benefit from the tax advantages.

Exploring Tax-Deferred Accounts

Tax-deferred accounts allow you to realize immediate tax deductions on the full amount of your contribution, but future withdrawals from the account will be taxed at your ordinary-income rate. The most common tax-deferred retirement accounts in the U.S. are traditional IRAs and 401(k) plans. In Canada, the most common is a Registered Retirement Savings Plan (RRSP).

Basically, these accounts allow you to delay paying taxes on your income until a later date.

For example, if your taxable income this year is $50,000 and you contributed $3,000 to a tax-deferred account, you would pay tax on only $47,000. In 30 years, once you retire, if your taxable income is initially $40,000, but you decide to withdraw $4,000 from the account, taxable income would be bumped up to $44,000.

Understanding Tax-Exempt Accounts

Tax-exempt accounts, on the other hand, provide future tax benefits because withdrawals at retirement are not subject to taxes. Since contributions to the account are made with after-tax dollars, there is no immediate tax advantage.

The main benefit is that investment returns grow without being taxed. In the U.S., popular tax-exempt accounts include the Roth IRA and Roth 401(k), while in Canada, it's the Tax-Free Savings Account (TFSA).

If you contributed $1,000 into a tax-exempt account today and the funds were invested in a mutual fund, which provided a yearly 3% return, in 30 years the account would be valued at $2,427. By contrast, in a regular taxable investment portfolio where one would pay capital gains taxes on $1,427, if this investment were made through a tax-exempt account, growth would not be taxed.

With a tax-deferred account, taxes are paid in the future but with a tax-exempt account, taxes are paid right now. However, by shifting the period when you pay taxes and realizing tax-free investment growth, major advantages can be realized.

Maximizing Benefits With Tax-Advantaged Investments

Tax-advantaged investments shelter some or all of an investor’s income from taxation, allowing them to minimize their tax burden. Municipal bond investors, for example, receive interest on their bonds for the duration of the bond’s life.

Municipal authorities use the proceeds from these bonds for community capital projects. To incentivize more investors to purchase these bonds, the interest income received by investors is not taxed at the federal level. In many cases, if the bondholder resides in the same state where the bonds were issued, their interest income will also be exempt from state and local taxes.

Depreciation also yields tax advantages for individuals and businesses that invest in real estate. Depreciation is an income tax deduction that allows a taxpayer to recover the cost basis of certain property. In the U.S., the cost of acquiring a land or building is capitalized over a specified number of useful years by annual depreciation deductions.

For example, assume an investor purchases a property for $5 million (the cost basis). After five years, the investor has depreciation deductions of $500,000 and their new cost basis is $4.5 million. If sold for $5.75 million, the investor's gain would be $1.25 million. The $500,000 deduction will be taxed at the depreciation recapture rate and the remaining $750,000 will be taxed as a capital gain.

Features of Tax-Advantaged Accounts

With regular brokerage accounts, the IRS taxes investors on any capital gains realized from selling profitable investments. However, tax-advantaged accounts allow an individual’s investing activities to be tax-deferred and, in some cases, tax-free. Traditional individual retirement accounts (IRAs) and 401(k) plans are examples of tax-deferred accounts in which earnings on investments are not taxed every year.

Taxes are deferred until retirement, when withdrawals can begin. Withdrawing from these accounts without penalty is allowed once the account holder turns 59½ years old.

Prior to the passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act, which was signed into law on December 20, 2019, once an account holder turned 70½ years, they were obligated to begin taking required minimum distributions (RMDs) from their tax-deferred retirement accounts. With the SECURE Act, required minimum distributions start at 72, and there's no age limit for contributing to a traditional IRA, similar to a Roth IRA.

The threshold to begin receiving distributions was changed once again when Congress approved and passed the SECURE Act 2.0 in December 2022. Individuals must begin taking RMDs when they turn 73 on or after Jan. 1, 2023.

The Bottom Line

Roth IRAs and FSAs offer even more tax savings for investors than tax-deferred accounts, as activities in these accounts are exempt from tax. Withdrawals and earnings in these accounts are tax-free, providing a perfect example of a tax advantage.

Governments establish tax advantages to encourage private individuals to contribute money when it is considered to be in the public interest. Selecting the proper type of tax-advantaged accounts or investments depends on an investor's financial situation.