8 Tax-Advantaged Accounts You Should Consider

Getting serious about your money means getting serious about taxes. If you are interested in building wealth over the long term, then it is important to understand when and how your money is taxed and how that affects your savings.

In this blog, we take a look at which types of tax-efficient investing work as well as how different types of tax-advantaged accounts can help you get more out of the money you are setting aside for a house, college tuition, retirement, or other long-term savings goals.

Read on to learn how getting smart about taxes today can help you build a better tomorrow.

What Is a Tax-Advantaged Account?

Tax-advantaged accounts are designed to help people save for important goals in life like college, a mortgage, and especially for retirement. Federal and state governments consider saving for these goals to be so beneficial to you and your family’s future well-being that they are willing to reduce or eliminate taxes on money in certain types of accounts.

Usually, earnings that you set aside have already been taxed even before they made it to your paycheck. Whenever you choose to save or invest money, the interest and dividend payments are also subject to tax, normally either as an annual dividend income tax or as capital gains tax when you sell an investment.

Understanding Taxable vs. Non-Taxable Accounts

Tax-advantaged accounts aim to ensure that you are not taxed twice on the same money and that you can pay a lower rate on savings than you might normally have paid. Most tax-advantaged accounts aim to reduce the tax burden your money attracts in one of two ways:

• Tax-deferred accounts allow you to contribute money from your earnings before it is taxed. This money, plus the interest it accrues, is taxed when you withdraw it.
• Tax-exempt accounts usually accept contributions from your post-tax incomes, but allow you to withdraw and spend it tax-free, subject to certain restrictions.

Some specialized tax-exempt health and savings accounts are truly non-taxable, meaning you are able to make contributions from your pre-tax earnings and withdraw them later free of tax.

Usually, however, accounts are considered tax-exempt because all contributions are made from your post-tax income. The key difference between them is when your money is actually taxed—before it is contributed or when you withdraw it.

Depending on whether you expect to pay a higher tax rate when you are making contributions or at the time you withdraw money, a tax-exempt or tax-deferred savings or investment vehicle ensures your money is taxed at the lowest possible rate.

Related: 13 Costly Retirement Mistakes to Avoid

Tax-Efficient Investing in Action

Let’s take a look at eight key types of tax-advantaged accounts designed to help you afford health and education expenses and plan better for retirement.

1. 401(k) Plans

A 401 (k) plan is a tax-deferred retirement savings account offered by a company to its employees as part of their work benefits package. Contributions are taken from your pre-tax earnings, invested, and taxed when you withdraw them after retirement.

401(k) plans offer a straightforward way for most people to plan for retirement. As you are more likely to be taxed at a lower rate post-retirement than when you are working (unless you invest or inherit a great deal of money) they usually offer a significant tax advantage to investors.

401(k) Plans

Pros:

Employer match: Many employers offer to match your contributions up to a certain percentage of your income, which can significantly boost your savings.

Tax-deferred growth: Investments grow tax-free until you withdraw them, potentially leading to a larger retirement fund.

Automatic contributions: Money is automatically deducted from your paycheck, making it an easy and consistent way to save.

Cons:

Penalties for early withdrawal: You will face penalties and additional taxes if you withdraw funds before age 59½, making it less flexible than other savings options.

Limited investment options: Funds are invested as your employer’s investment advisors see fit, which may suit your investment goals.

Required minimum distributions: You are required to begin taking distributions at age 72, even if you do not need the funds at that time.

2. Traditional IRAs

A traditional IRA (Individual Retirement Account) is a bit like a private 401(k). It’s a smart choice for most people, whether or not you have retirement benefits through your job. While contributions are made from your earned income, these can often be deducted from your taxable income for the year. Savings are not taxed until withdrawal after the age of 59½.

While there is a limit to the amount you can contribute each year, most IRAs allow you to defer taxes on at least some of your earnings provided you are in a lower tax bracket after retirement. You also have the freedom to invest the money as you see fit.

Traditional IRAs

Pros:

Annual tax deduction: Contributions to a traditional IRA may be fully or partially deductible, depending on income and whether you or your spouse have a 401(k).

Tax-deferred growth: The investments in your IRA grow tax-deferred until withdrawals begin, allowing you to accumulate more than if you had simply saved post-tax earnings.

Investment choices: You have the freedom to choose from a wide range of investment options to fit your personal retirement goals.

Take it with you: Can roll money from a company 401(k) into a traditional IRA if you change jobs.

Cons:

Penalties for early withdrawal: Withdrawing funds before age 59½ usually results in a 10% penalty and income tax on the amount withdrawn.

Mandatory distributions: Starting at age 72, you are required to take minimum distributions from your savings whether you need to or not.

Contribution limits: There are limits to how much you can contribute to an IRA each year, and tax-deductible contributions are phased out at higher income levels. Contribution limits are typically lower than for 401(k)s.

At Emergent Financial Group, we make savings for retirement easy with flexible traditional IRA savings options and generous rates to maximize your earnings. You can also consult with our investment experts about the advantages of investing in mutual funds, ETFs, and annuities.

3. Roth IRAs

A Roth IRA is a personal retirement account that allows your money to grow tax-free using contributions made from your after-tax earnings. Unlike a traditional IRA or 401(k), where taxes are deferred until withdrawal, the money you put into a Roth IRA has already been taxed.

You can withdraw your contributions and earnings tax-free after the age of 59½ provided the account has been open for at least five years. Roth IRAs make sense for people who expect to be in a higher tax bracket after they retire due to other sources of income or for those who simply prefer the certainty of tax-free withdrawals.

Roth IRAs

Pros:

Tax-free growth and withdrawals: Contributions grow tax-free and withdrawals in retirement do not incur taxes.

No required minimum distributions: Unlike traditional IRAs, Roth IRAs do not require you to start taking distributions at a certain age, allowing your investments to continue growing if you don’t need the funds.

Withdraw contributions anytime: You can withdraw the money you’ve contributed (but not the earnings on those contributions) at any time, without taxes or penalties.

Cons:

Income limits: There are annual income limits that phase out contributing to a Roth IRA that may cap the benefits they offer to higher earners.

No annual tax break: Contributions are made with after-tax dollars, so you won’t get a break on your annual taxes, as you do with traditional IRAs.

Tax-advantage limits: Roth IRAs can offer big tax advantages, but only if you have the resources to pay the upfront taxes while not exceeding income limits on contributions.

Talk to the retirement savings experts at Emergent Financial Group about whether a Roth IRA is right for your financial situation. We offer both Roth IRA certificates and Roth IRA savings accounts.

4. Roth 401(k) Plans

A Roth 401(k) is a less common version of a traditional 401(k) that allows you to contribute part of your post-tax income to a plan sponsored by your employer. Your employer may also match a portion of your contributions to the plan.

While you will miss out on the tax savings offered by a traditional 401(k), you will enjoy tax-free growth and the certainty of tax-free withdrawals after age 59½. This type of plan makes sense for employees who expect to be in a higher tax bracket after retirement or who don’t want to worry about being taxed while in retirement.

Roth 401(k) Plans

Pros:

Tax-free withdrawals: Distributions of contributions and earnings are tax-free as long as the account has been open for five years and you are at least 59½ years old.

Higher contribution limits: Roth 401(k)s offer the higher contribution limits of traditional 401(k) with the tax-free growth of a Roth IRA.

Possible employee match: A generous employer might also match some of your contributions to a Roth IRA, offering a double-whammy on a portion of what you put in.

Cons:

Required distributions: Unlike Roth IRAs, Roth 401(k)s require mandatory distributions from age 72. This can often be avoided by rolling the account over into a Roth IRA.

No annual tax break: Contributions are made with your taxed income, so there’s no tax relief during your contribution year.

Limited availability: Not all employers offer a Roth 401(k) option as part of their retirement benefits package.

5. 529 College Savings Plans

529 college savings plans are offered by states or educational institutions and are meant to help parents “hedge” against the skyrocketing cost of college education. Accounts allow contributions to grow tax-free until needed and can generally be used for a wide range of qualifying education expenses from tuition to books to technology.

Plans offered by individual colleges require that saved funds be spent on tuition at that college or institution. State funds, on the other hand, can sometimes be used to help fund education at a wide range of post-secondary institutions including two-year colleges and trade schools. Some even allow savings to be spent on K-12 education.

Some states also offer tax deductions or credits for contributions to 529 plans, potentially making this a fully tax-exempt way to save for higher education.

529 College Savings Plans

Pros:

Tax-free growth and withdrawals: Earnings in a 529 plan grow tax-free, and withdrawals are not taxed when used for qualified education expenses.

High contribution limits: 529 plans typically have very high contribution limits, allowing families to save substantial amounts for education expenses.

Flexibility and control: The account owner keeps control of funds and can change the beneficiary if the original beneficiary does not need the money for education.

Cons:

Limited investment options: Investment options in 529 plans are often limited to a selection provided by the plan.

Penalties for non-qualified withdrawals: Non-qualifying withdrawals (funds not used for education expenses) are taxed and are subject to a 10% penalty on earnings.

Potential impact on financial aid: 529 plan savings might affect a student’s eligibility for financial aid, although these are generally treated more favorably than some other assets.

6. Coverdell Education Savings Accounts

Coverdell Education Savings Accounts (ESAs) offer a flexible way for families to prepare (and share) the cost of a child’s education from pre-K through to higher education. Contributions are made from the after-tax earnings of parents, grandparents, or extended family members and grow tax-free until needed for a wide range of qualified education expenses.

Coverdell ESAs

Pros:

Flexible use of funds: Unlike many 529 plans, all Coverdell ESAs can be used for qualified educational expenses from kindergarten through post-secondary education.

Flexible in directing funding: A Coverdell ESA allows you to change the beneficiary of your Coverdell ESA or reallocate unused funds, depending on your family’s needs.

Flexible investment strategies: Choose an ESA with an investment strategy that matches your goals. Opt for higher risk or play it safe with sure-fire income earners.

Cons:

Contribution limits: Coverdell ESAs have an annual contribution limit of just $2,000 per beneficiary, which limits how much can be saved before a child needs the funds.

Income restrictions: There are also income limits for contributions to Coverdell ESAs, making them less useful as a savings strategy for higher-earning families.

Age limitations: All funds must be used by the time the beneficiary turns 30 (with certain exceptions), which limits their usefulness, for example, to older students.

Coverdell ESAs do have more flexible provisions for beneficiaries with certain disabilities including a higher age limit, which makes them a potentially useful tool for families with students who have health or learning challenges.

7. Health Savings Accounts

Health Savings Accounts (HSAs) are often offered to holders of high-deductible health plans to help them manage significant out-of-pocket expenses. Contributions to an HSA are tax deductible. Savings and withdrawals are also not taxed, making this a truly non-taxable investment option with significant growth potential.

HSAs

Pros:

Preventative care: HSAs can be spent on a wide range of preventative care services, allowing you to cover many of the services covered by more expensive health plans.

Investment options: Many HSAs offer the ability to invest contributions in stocks, bonds, and mutual funds, similar to retirement accounts.

Portability and long-term savings: HSAs are owned by the individual, not tied to an employer, and the funds roll over year to year with no requirement to spend, making this a good way to build long-term health savings.

Cons:

High-deductibles only: Only individuals with qualifying high-deductible health plans can open an HSA. This may not be ideal for those with significant medical needs.

Complex rules for spending: While HSAs offer tax-free withdrawals for qualified medical expenses, there can be confusion over exactly what care qualifies.

Contribution limits: There are annual contribution limits to HSAs ($4,150 for individuals and $8,300 for families in tax year 2024).

8. Flexible Spending Accounts (FSAs)

Unlike HSAs, Flexible Spending Accounts (FSAs) are typically offered by employers. They allow employees to contribute savings that can be used for qualified medical expenses. While FSA contributions allow employees to reduce their annual taxable income, these funds are owned by the employer and may be lost if not spent within a given plan year.

FSAs make good sense for busy families looking to reduce both their regular preventative medical care costs and their annual tax burden. Best of all, they can be paired with lower deductible plans that kick in to pick up where your available cash leaves off.

FSAs

Pros:

Immediate tax savings: FSA contributions are deducted from your salary before taxes, giving you a valuable tax break on one of your biggest monthly expenses.

Reduces out-of-pocket expenses: By using pre-tax dollars for medical expenses, FSAs effectively reduce the cost of your healthcare.

No high-deductible requirement: Unlike high-deductible health plans, FSAs have few eligibility requirements, making them accessible to more employees.

Wide coverage: FSAs can typically be used for a broad array of out-of-pocket healthcare expenses including deductibles, copayments, prescription medications, and certain over-the-counter items.

Cons:

Use it or lose it: Funds not used by the end of the plan year (or the additional grace period) are returned to your employer.

Limited carryover: Some plans allow you to carry over some funds, but these amounts are typically limited and not offered by all employers.

Employer control: Since your employer owns the funds in your FSA, you can’t take the money with you if you change jobs.

At Emergent Financial Group, our mission is simple:

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