“Tax-advantaged” is a broad term covering investment, savings, and other types of financial accounts that offer tax benefits. Common examples are individual retirement accounts (IRAs) or 401(k)s, but certain municipal bonds, partnerships, and annuities also fit the bill.
Tax-advantaged accounts can lower your tax liability. How they do this depends on what type of tax-advantaged account it is: tax-deferred or tax-exempt. Examples of tax-deferred accounts include 401(k)s and traditional investment retirement accounts (IRAs). Tax-exempt accounts include Roth 401(k)s and IRAs. Read on to explore the differences between tax-deferred and tax-exempt in the following sections.
Tax-deferred accounts allow users to deduct the contributions they make on their taxes, lowering their tax liability in the year of contribution. Many tax-advantaged investments fall into this category and include traditional IRAs, 401(k)s, and 529 plans. It’s important to understand what “tax-deferred” means exactly. While the user doesn’t pay tax on the contribution at the time it’s made, taxes are due at the time of withdrawal — which is usually in retirement, when most people’s tax rate is lower than during their peak earning years. Let’s dive deeper into some of the most common tax-advantaged accounts.
A 401(k) account is a company-sponsored tax-advantaged investment account, in which an employee may contribute a part of his or her paycheck with the employer often matching a portion of that contribution. The plan typically offers a range of investment options from low to high risk, usually in mutual funds.
This type of account is called a 401(k) after the section of the U.S. Internal Revenue Code that created the plan. A 401(k) account is tax-advantaged because employee contributions are made pre-tax, which reduces your taxable income, but as mentioned above: withdrawals are taxed, which is why it’s classified as a tax-deferred account. Contribution limits for 2023 are $22,500 for those under 50, with a $7,500 catch-up contribution for those over 50.
Similar to 401(k)s, 403(b) accounts are tax-advantaged too, but are typically designed for non-profit or tax-exempt companies. Employees enrolled in a 403(b) can contribute savings pre-tax and the employers may match those contributions. The investment options are similar to 401(k)s but may be more limited in some cases. However, vesting of the employer contribution may be faster for 403(b)s compared to 401(k)s, but withdrawals are taxed just like a 401(k).
Teachers, professors, government employees, and healthcare workers are the most common 403(b) participants. Like the 401(k), the 403(b)s tax advantage is primarily due to the reduction in taxable income. Contribution limits for 403(b)s are the same as 401(k)s: $22,500 for employees under 50, and a $7,500 catch-up contribution for those ages 50 and up.
Another type of tax-advantaged investment account is the 457 Plan. This plan is similar to 401(k)s and 403(b)s, however, it’s generally restricted to employees of public service or tax-exempt organizations. The tax advantages offered by 457s are similar to 401(k)s and 403(b)s, but contribution limits are often different. In 457s, employees may contribute as much as 100% of their salaries if that salary falls within a dollar limit set by the IRS.
There are also different types of 457s. The 457(b) is offered to state and local government employees, while the 457(f) is offered to highly compensated executives in tax-exempt organizations and functions as a deferred salary plan. Contribution limits for 457s are the same as 401(k)s and 403(b)s.
Unlike 401(k)s and other accounts mentioned above — which are company-sponsored — traditional individual retirement accounts (IRA) are opened by an individual through a brokerage firm or financial advisor. Capital gains and dividends on the investments are not taxed until withdrawal, similar to 401(k)s. Contribution limits for 2023 are $6,500 for those under 50, and $7,500 for those over.
Generally, individuals can deduct all of their contributions from income unless they or their spouse is covered by a retirement plan at work, such as a 401(k). If that's the case, the following limits apply: Single filers earning less than $73,000 or married filers earning less than $166,000 in 2023 are able to deduct the full contribution from their earnings. If you earn more than that, the contribution limit declines until you exceed $78,000 in earnings for single or $129,000 in earnings for married filers, after which the deduction is completely phased out. Be sure to check with your CPA or financial advisor to find out the specifics as well as how the IRS defines earnings for the IRA contribution limits. Don’t have an advisor yet? FinanceHQ can seamlessly connect you with top financial advisors who can help build your plan with confidence.
We’ve discussed various tax-advantaged accounts, and now we’ll examine what are typically considered after-tax or tax-exempt accounts. These include Roth IRAs and 401(k)s as well as tax-free savings accounts. It’s important to note that although these accounts may be considered tax-exempt, they are not exactly tax-free, as we’ll explain below.
A Roth IRA is a special type of IRA in which an individual contributes after-tax earnings. The account holder may choose from a range of investment options. The main tax advantage is that the growth, interest, or dividends that accrue from the investments are not taxed upon withdrawal, which is usually not allowed before the account holder reaches 59½ years of age and has had the account open for five years.
Importantly, single filers earning more than $153,000 and married filers earning more than $228,000 in 2023 can’t contribute to a Roth IRA. If you earn less, contribution limits are $6,500 plus another $1,000 if you’re over 50.
Just like the various 401(k), 403(b), and 457 plans offered by employers, there are also Roth versions of all of these, which have some similarities and important differences. Roth versions share similar contribution limits, but contributions are after-tax.
Importantly, if your employer contributes to any type of Roth plan, their contribution is treated like a traditional 401(k), 403(b), or 457. This means withdrawals from the employer portion of the Roth plan are taxed, even though withdrawals from the employee’s contributions are tax-free. This does create some additional complexity at tax time, which is why it’s helpful to consult a financial advisor for your unique situation.
There are other accounts that offer tax advantages and are designed to save for goals like college or spending on healthcare. Let’s check out a few of these tax-advantaged accounts.
A 529 plan is a tax-advantaged savings account designed to save for education. It’s typically set up by parents to pay for their children’s college, but can also be used for K-12 tuition and student loan payments. Each state has its own 529 plan, although participants don’t have to live in that state to enroll. Contributions are made post-tax, and a range of investment options are available similar to — but often not as diverse — as 401(k)s. Investment returns and earnings accrue tax-free, provided withdrawals are used for qualified purchases.
Contribution limits vary by state from $235,000 to as high as $529,000, so you’ll need to check with each state or a financial advisor for specifics. Importantly, contributions above the $17,000 threshold for 2023 count toward the lifetime gift tax exemption of $12 million for single individuals or $25 million for married couples. While those amounts might not be relevant for many folks, it’s something to consider if there are plans for large gifts later in life.
However, there is an exception that allows someone to make a lump sum contribution equivalent to five years of gifts without counting toward the lifetime exemption, provided no other contributions are made for the next five years.
Health Savings Accounts (HSAs) offer individuals a way to save for medical expenses by contributing pre-tax earnings. Like 401(k)s, this contribution reduces taxable income and thus confers an HSA’s main tax advantage. Other tax advantages include the fact that investment growth accrues tax-free and qualified withdrawals — such as ones used for medical expenses — are tax-free too.
In some cases, non-medical-related expenses may also be tax-free after a certain period of time. To qualify for an HSA, you need to be enrolled in a high-deductible health insurance plan. Contribution limits are $3,850 for individual health plans and $7,750 for family plans in 2023.
Flexible spending accounts (FSAs) are established by employers to help employees save for medical and dental expenses. The employee contributes pre-tax earnings and can withdraw those savings to use on qualified expenses without having to pay tax, hence the tax advantage. While the FSA sounds similar to an HSA, there are important differences.
First, FSAs don’t offer investment options like an HSA, so the funds do not have the potential to grow. Second, all the money in the FSA must be used by the end of the year — the “use or lose it” provision. However, employees are usually eligible for FSAs regardless of insurance plan. An additional type of FSA allows individuals to use savings to pay for childcare expenses, known as a dependent care flexible spending account. Contribution limits for a dependent FSA are different from a regular FSA. Contribution limits are $3,050 for 2023.
What is the best tax-advantaged account: one that is tax-deferred or tax-exempt? The answer depends a lot on your circumstances and preferences. Critically, what is your tax status? Are you in the early stages of your career where your earnings are lower than they will be in the future? In such a case, a Roth IRA is probably a better option to start with, given the investments one makes now have the potential to grow tax-free for many years.
If you believe that you’re at the highest tax bracket in your lifetime earnings, then tax-deferred accounts like 401(k)s or 403(b)s — which reduce your current taxable income — are often preferable. Whatever your circumstances, the key takeaway is that employing a tax-deferred or tax-exempt savings account is one of the best ways to lower your tax bill either today or in the future.
One important point to note is that you can have multiple tax-advantaged accounts. Contributing to a 401(k) doesn’t preclude you from also contributing to an FSA and opening a 529. Navigating all these options and weighing the alternatives can seem overwhelming. This is where a good financial advisor can help not only clarify what to focus on, but also help formulate a plan that can take advantage of the different benefits without making it all so complicated.
Choosing the right account depends on many factors. Since everyone’s circumstances are different, it’s tough to offer specific recommendations. Here are some broad guidelines to follow:
If your company offers any type of tax-advantaged retirement savings account, it’s probably a good idea to enroll. You’ll lower your taxable income and may enjoy some employer contributions to boot.
If you have a good idea of what you’ll need to spend on medical or dental bills in the coming year — such as a planned surgery or pregnancy — you can enroll in an FSA. If you’re relatively young, healthy, and don’t foresee a lot of medical expenses in the coming years, consider enrolling in a high-deductible medical insurance plan and opening an HSA.
Clearly, these recommendations just scratch the surface. Most people will have a lot more questions and circumstances that won’t fit into easy categories. A family of four with 401(k)s, looking to save for college and regular medical bills will have many different questions compared to a widow who is 10 years away from retirement.
This is where a competent financial advisor can help. FinanceHQ’s qualified financial advisors help clients meet long-term financial goals. They can answer questions about choosing the right tax-advantaged account, address most of their client’s needs, and come up with a good plan to maximize the benefits we’ve discussed. Our financial advisors also offer other key services like tax and estate planning, insurance and healthcare planning, formulating a budget as well as investment management. Ultimately, if you’re not sure what’s best for you, consider working with one of our professionals who can help you reach your financial goals.
Sharon O' Day has been writing in the personal finance space for half a decade, with an MBA in Finance from the Wharton School.