What Is Tax-Advantaged?

What Is Tax-Advantaged?

You need to know that tax-advantaged investments and accounts give you major tax benefits, letting you build your wealth while cutting down on taxes. These come mainly as tax-deferred or tax-exempt.

With tax-deferred accounts like traditional IRAs and 401(k) plans, you put off taxes on earnings until you withdraw them. Tax-exempt accounts like Roth IRAs let your money grow tax-free, and you can pull it out without taxes after retirement. I recommend understanding these differences so you can adjust your investment strategy to fit your finances and get those long-term tax perks.

Key Takeaways

Tax-advantaged accounts are tools that give you tax exemptions or deferrals on investments, helping you save more and pay less in taxes. For tax-deferred ones like traditional IRAs and 401(k)s, your contributions grow without taxes until you take them out, offering upfront deductions but taxes later on withdrawal.

Tax-exempt accounts like Roth IRAs don't give you a tax break right away, but your investments grow and come out tax-free in retirement. Things like municipal bonds and real estate depreciation are tax-advantaged investments that cut your taxable income through tax-free interest or deductions.

The SECURE Act and SECURE Act 2.0 have changed rules for retirement accounts, like raising the age for required minimum distributions and allowing contributions to traditional IRAs without age limits, so you should stay updated on these policy shifts.

How Tax-Advantaged Accounts Work

Investors and employees from all walks of life use tax-advantaged investments and accounts. If you're a high-income earner, you might go for tax-free municipal bond income, while if you're an employee, you're likely saving for retirement through IRAs or employer plans.

The key ways to reduce your tax bills are through tax-deferred or tax-exempt statuses. You have to decide which one—or both—works for you based on when you want those tax benefits.

Exploring Tax-Deferred Accounts

Tax-deferred accounts let you get immediate tax deductions on your full contribution, but you'll pay taxes on withdrawals at your ordinary income rate later. In the U.S., the common ones are traditional IRAs and 401(k) plans; in Canada, it's the Registered Retirement Savings Plan (RRSP).

Essentially, these accounts let you push taxes on your income to a future date. For instance, if your taxable income is $50,000 this year and you put $3,000 into a tax-deferred account, you only pay taxes on $47,000. Thirty years from now in retirement, if your taxable income starts at $40,000 and you withdraw $4,000, it bumps up to $44,000 for taxes.

Remember, the SECURE Act updated rules for tax-advantaged retirement and savings plans, including traditional IRAs and 529 accounts.

Understanding Tax-Exempt Accounts

Tax-exempt accounts give you future tax benefits since retirement withdrawals aren't taxed. You make contributions with after-tax dollars, so there's no immediate tax break.

The big plus is that your investment returns grow tax-free. In the U.S., think Roth IRA and Roth 401(k); in Canada, it's the Tax-Free Savings Account (TFSA).

Say you put $1,000 into a tax-exempt account today, invested in a mutual fund with a 3% yearly return—in 30 years, it's worth $2,427. In a regular taxable portfolio, you'd pay capital gains on $1,427 of that growth, but in a tax-exempt account, none of it gets taxed.

With tax-deferred, you pay taxes later; with tax-exempt, you pay now. By shifting when you pay and getting tax-free growth, you can gain serious advantages.

Maximizing Benefits With Tax-Advantaged Investments

Tax-advantaged investments protect some or all of your income from taxes, helping you minimize what you owe. Take municipal bonds: investors get interest throughout the bond's life, and municipal authorities use the money for community projects. To attract buyers, that interest isn't taxed federally, and often not at state or local levels if you live in the issuing state.

Depreciation offers tax perks for real estate investors. It's a deduction that lets you recover the cost of property over time. In the U.S., you capitalize the cost of land or buildings and deduct annually over useful years.

For example, if you buy a property for $5 million, after five years with $500,000 in depreciation deductions, your cost basis drops to $4.5 million. Sell it for $5.75 million, and your gain is $1.25 million—$500,000 taxed at depreciation recapture rate, the rest $750,000 as capital gain. Without depreciation, the whole gain would be taxed as capital gain.

Features of Tax-Advantaged Accounts

In regular brokerage accounts, the IRS taxes you on capital gains from selling winners. But tax-advantaged accounts defer taxes on your investing, or make them tax-free in some cases. Traditional IRAs and 401(k)s defer taxes on earnings until retirement withdrawals start.

You can withdraw without penalty at 59½. Before the SECURE Act of 2019, you had to start required minimum distributions (RMDs) at 70½. Now it's 72, and there's no age limit for traditional IRA contributions, like with Roth IRAs.

SECURE Act 2.0 in 2022 pushed RMDs to 73 starting January 1, 2023.

What Is Traditional IRA vs. Roth IRA?

Traditional IRAs are tax-deferred, while Roth IRAs are tax-exempt. With traditional, your contributions deduct from taxable income for an immediate break. Roth gives no upfront deduction, but gains are tax-free on withdrawal.

At What Age Does a Roth IRA Not Make Sense?

You can contribute to a Roth IRA at any age—no mandatory RMDs like traditional IRAs. But there's a five-year rule: wait five years after your first contribution to withdraw earnings. That could influence your decision.

Should I Contribute to Roth or Traditional IRA First?

It depends on your expected future income. If you think it'll be lower in retirement, prioritize traditional IRAs for the immediate tax advantages. If you expect higher income and tax rates later, go for Roth first since withdrawals will be tax-free.

The Bottom Line

Roth IRAs and similar accounts like FSAs provide more tax savings than deferred ones because everything is tax-exempt—withdrawals and earnings are tax-free. Governments set up these advantages to encourage contributions for public good. Pick the right tax-advantaged accounts or investments based on your own financial setup.