The average adult in the US pays just shy of 30% of their income in federal taxes for an average of a little over $18,300 out of their paycheck annually. If you’re like a lot of people, you’d prefer hanging on to some of that money you lose in taxes.
Well, it turns out that there are some tax advantaged accounts out there that can help you do just that. While these accounts won’t let you dodge your tax burden entirely, they can help minimize the taxes you pay on your income.
Not familiar with tax advantage accounts? Keep reading for our quick guide to help you navigate these account options.
Tax advantaged vs Taxable Account
Broadly speaking, tax advantaged accounts simply provide you with an investment account that offers some tax benefit by either delaying your taxes or eliminating later taxes. You typically enjoy those benefits by accepting limitations, such as a hard cap on how much you can put into the account each year or penalties for early withdrawal.
A taxable account, by contrast, is an investment account that doesn’t offer you any tax benefits but also frees you from any limitations. With taxable accounts, you can typically put in and take out as much as you want.
Pre-Tax and Post-Tax
Tax advantaged accounts are a staple in tax efficient investing. In most cases, your primary decision is whether you want a pre-tax or post-tax investment account.
Your basic 401(k) is a pre-tax investment account. You contribute from your untaxed earning and take a deduction now, then pay taxes at withdrawal.
These are typically the preferable tax-advantaged accounts for high-income earners because they offer these advantages. These are considered tax deferred investments.
Your basic Roth IRA is a post-tax investment account, which means you contribute income after you pay taxes on it. The upshot is that you don’t pay any taxes when you withdraw from the account.
Types of Tax Advantaged Accounts
There are a number of common tax-deferred accounts that you might invest in depending on your situation or employer, such as:
- 401(k) for private employers
- Traditional IRA
- 403(b) for non-profit organizations
- 457 plans for local or state government employees
The after-tax options include Roth-style 401(k), 403(b), and 457 plans that let you pay taxes now for tax exemptions later, as well as the standard Roth IRA.
You can also consider Health Savings Accounts as tax-advantaged accounts since you can take deductions on contributions now and withdrawals are tax-free. The catch is that any future withdrawals must pay for health-related expenses, such as doctor appointments or medications.
Tax Advantaged Accounts and You
For anyone looking down the road toward retirement, tax advantaged accounts are something of a no-brainer. You keep your current or future tax burden down and grow savings for your retirement years.
The real question you must answer, likely with some input from an accountant, is whether a tax-deferred account or tax-exempt account makes more sense for you.
Looking for more personal finance tips? Check out the posts over in our Finance section.