Tax-advantaged investments are ones that are either tax-exempt, tax-deferred, or offer other types of tax benefits.
Tax-advantaged accounts hold your tax-advantaged investments while regular taxable brokerage accounts can hold tax exempt investments (or tax-free investments) that do not require you to pay any taxes on income or gains.
Tax-deferred investments require you to pay taxes but not until a later date (usually years in the future) when you withdraw funds.
If later in life you earn income in a lower income bracket when you pull funds out, you only pay tax at the lower rate for your current income level and not the higher rate of when you started investing the money.
Some people have after-tax investment accounts which they have funded with earnings you have paid taxes on already. The advantage of these accounts is that you do not have to pay taxes on any of your investment earnings.
While your entire investment strategy should not revolve around tax advantages, people who pay attention to these benefits can save themselves a significant amount of money.
These are some of the most popular tax-advantaged investments for building wealth and the requirements to partake in them.
Best Tax-Advantaged Accounts
1. Traditional 401(k) Plans
Typically, 401(k) savings plans come from large, for-profit businesses who offer them to their eligible employees. These employees choose a tax-deferred contribution amount that follows that particular employer’s investment options.
Some employers will also contribute to the employees’ 401(k) plans, often in terms of a percentage match. Wages you contribute always remain yours, even if you leave that company, but they may fall subject to a vesting schedule.
You can choose to keep the money in their 401(k) plan, transfer it to a new employer’s plan, or roll it into a Traditional IRA without paying penalties or fees. To withdraw money to use, you have to wait until you have reached age 59 ½ or face a 10% penalty the year you withdraw.
Past age 59 ½, the IRS taxes your withdrawals at your income rates for the year. At age 70 ½, you must begin taking required minimum distributions.
2. 403(b) Plans & 457 Plans
Both 403(b) plans and 457 plans have very similar features to 401(k) plans. The difference is that 403(b) plans are for employees of non-profit, tax-exempt business, such as schools, churches, or hospitals.
Employees fund these accounts with tax-deferred contributions and accumulated earnings which do not go to shareholder dividends. Like a 401(k) account, tax rules and contribution limits apply.
457 plans, on the other hand, act like 401(k) plans but for government employees, though they offer a few additional benefits as well. Some employers allow double contributions when people reach a three year window of their plan’s normal retirement age.
Additionally, some employers offer both a 401(k) or 403(b) as well as a 457 plan and you can fund both. While early withdrawals from 457 plans are subject to taxes, they do not face the 10% penalty.
3. Traditional IRA
A traditional Individual Retirement Account (IRA) is a tax-deferred investment account available through numerous brokerages and investing services. As long as you are younger than 72, you can deduct contributions on your tax return the year you contribute to the account.
When you withdraw after age 59 ½, you pay income taxes at your marginal tax bracket. Hopefully this happens after you have moved to a lower tax bracket than when you added to it in your earning years.
If you withdraw before that age, you’ll need to pay the 10% early withdrawal penalty (unless you meet an exemption requirement). Note that some years you might not be allowed to use your IRA contribution as a tax deduction.
This could happen if your modified adjusted gross income goes over the income threshold, so check requirements carefully.