Tax-advantaged investments are ones that are either tax-exempt, tax-deferred, or offer other types of tax benefits. Tax exemption investments (or tax-free investments) 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.
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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.
Consider opening an IRA account with Webull, one of the best stock trading apps for beginners. This will allow you to take advantage of their free trading commissions and receive free stocks at account opening.
4. Roth IRA
Switching gears, a Roth IRA is most beneficial for people who expect their tax rate to be higher during retirement. You pay tax up front on the money you put into this account, but the returns you earn are tax-free.
As another benefit, you don’t pay taxes when you take qualified distributions either. You can contribute to your Roth IRA at any age (including a custodial Roth IRA) as long as you earned taxable income and your modified adjusted gross income falls under applicable income limits.
You can contribute to both traditional and Roth IRAs, but the total contribution amount cannot surpass annual limits.
5. Roth 401(k), 403(b), 457 Plans
The main difference between a traditional 401(k) and a Roth 401(k) is that a Roth 401(k) is tax-deferred rather than giving you a benefit the year you contribute.
Distributions are tax-free if they have been in your plan for at least five years and you are at least 59 ½ years old when you withdraw. If you don’t follow those requirements, you’re subject to a 10% early withdrawal penalty.
Again, once you’re 72 you have to take distributions. You can avoid that by rolling your funds into a Roth IRA plan. You can contribute to both a traditional and Roth IRA as long as the total doesn’t exceed annual limits.
For Roth 403(b) or 457 plans, the same similarities and differences apply. The main difference is that taxes are deferred.
6. 529 Plan
In the past, you could use funds contributed to a tax-advantaged investment in a 529 Plan for college expenses. However, tax reform changed the rules to allow funds contributed to a 529 plan for any qualified educational expense from K-12 through college and graduate school.
In effect, a 529 savings plan acts as a tax-advantaged investment account helping your family save for education expenses. It works by contributing post-tax dollars into your investment account and then seeing your investments grow tax-free.
When the time arrives to pay for qualified education expenses (e.g., tuition & fees, room & board, books, computer, etc.), the withdrawals you make from the account come to you tax-free.
In the event you choose to withdraw earnings from the account for a non-qualified expense, you must pay applicable taxes and a 10% penalty.
In short, a 529 plan acts in a similar manner to a Roth IRA account, but instead of retirement, it goes toward planning for educational expenses for the designated account beneficiary.
What are the biggest benefits of contributing to a 529 plan?
- First, your investments grow over time. When comparing this to a typical savings account, the money invested in a 529 plan compounds over time.
- Second, the appreciation on investments held in the account does not get taxed if they are used for qualified educational expenses. In other words, the appreciation does not fall subject to federal income taxes nor, in most cases, state taxes. This keeps more money in your pocket for important expenses.
- Third, these funds do not remain forever locked in this account. In fact, because 529 plans act similarly to a Roth IRA, you retain the flexibility of withdrawing your original contributions (the “principal”) without additional taxes or penalties.
7. Health Savings Account (HSA)
Health Savings Accounts offer what is considered a triple tax benefit. If you have an employer-sponsored account, your contributions are taken out of your paycheck before taxes.
People can set up their own HSA and deduct their contributions to pay less in taxes that year. The money in your HSA grows on a tax-deferred basis and some accounts, like those from Lively, allow you to invest your savings in mutual funds or other types of investments.
You can withdraw money at any time for qualified medical expenses and the distribution is completely tax-free. However, if you withdraw funds not used for medical expenses before age 65, there is a 20% penalty.
After age 65, you are able to withdraw money for any purpose without penalty. You are at no point forced to take distributions. An additional benefit is that money in an HSA rolls over each year and isn’t lost if unused, making them one of the best investments for young adults.
Note that there are restrictions on who can open an HSA. To be eligible, you need to be enrolled in a High Deductible Health Insurance Plan (HDHP) and not receive Medicare.
You also cannot be covered under any disqualifying health coverage or claimed as a dependent on another person’s tax return.
8. Municipal Bonds
Municipal bonds (muni bonds) are used by state and local governments to fund projects, such as building new schools, office parks, or public infrastructure projects.
When you buy a bond, you loan money to the government for a predetermined amount of time and receive a virtually-guaranteed rate of return through interest payments from the bond paid twice a year.
Unlike with corporate bonds, the interest on municipal bonds is tax-exempt from federal taxes and, if those bonds are issued by the state you reside in, from state and local taxes as well.
Also, this is why you would want to hold muni bonds in a non-tax advantaged account- these bonds already avoid tax consequences. Muni bonds would not be the best investments for tax-deferred accounts.
If your income is over a certain limit, the interest may be subject to the Alternative Minimum Tax (AMT). When the bond matures, you get your principal amount back. It’s also possible to make money from municipal bonds by selling them at a higher price than you paid for them.
There is very little risk of default with these high-yield investments. However, inflation can affect the interest rate (and thus the rate of return).
9. Charitable Giving
The U.S. tax code has incentives for giving charitable gifts. If you itemize your taxes, you can deduct the value of your donation from your taxable income (limits apply).
There are several strategies to maximize your giving. Let’s say you donate $1,000 annually to the Books for Kids Foundation and another $1,000 for the Red Cross.
If you have a particularly high-income year, consider a donor-advised fund. A donor-advised fund can be thought of as a personal charitable savings account.
These are controlled by a nonprofit, referred to as a sponsoring organization, that invests the assets and manages your account. Some examples are Schwab Charitable and Vanguard Charitable.
You tell them which nonprofits you would like to donate to from your account. This fund would have more than your usual donations. You might put five years’ worth of donations into it.
The benefit is that you receive an immediate tax deduction during your high-earning year and you still have money set aside to donate to those charities over the next few years. Simply claim this deduction using the best tax software and track it with useful financial apps.
You can also maximize your giving by donating appreciated stock rather than cash. If you donate long-term appreciated stocks or mutual funds to public charities, you can deduct the fair market value of the stock (as opposed to your cost basis).
This might help to eliminate capital gains taxes you have during the year. Contributing real estate or privately held business interests can work similarly.
Why You Should Consider Tax-Advantaged Investments
With some careful planning, tax-advantaged investments can save you a substantial amount of money you would otherwise spend on taxes over the years. Take advantage of investments that are tax-exempt, deferred, or provide other tax breaks.
Just remember not to invest more than you can afford. Go over your expected earnings each year and don’t make any major investments without consulting with an expert or at least conducting thorough research. Taxes are unavoidable, but you can strategically make tax-advantaged investments toward financial independence.
About the Site Author and Blog
In 2018, I was winding down a stint in investor relations and found myself newly equipped with a CPA, added insight on how investors behave in markets, and a load of free time. My job routinely required extended work hours, complex assignments, and tight deadlines. Seeking to maintain my momentum, I wanted to chase something ambitious.
I chose to start this financial independence blog as my next step, recognizing both the challenge and opportunity. I launched the site with encouragement from my wife as a means to lay out our financial independence journey and connect with and help others who share the same goal.
I have not been compensated by any of the companies listed in this post at the time of this writing. Any recommendations made by me are my own. Should you choose to act on them, please see the disclaimer on my About Young and the Invested page.