What Is Tax-Advantaged?
The term tax-advantaged refers to any type of investment, financial account, or savings plan that is either exempt from taxation, tax-deferred, or that offers other types of tax benefits. Examples of tax-advantaged investments are municipal bonds, partnerships, UITs, and annuities. Tax-advantaged plans include IRAs and qualified retirement plans such as 401(k)s.
Key Takeaways
- Tax-advantaged refers to favorable tax status held by certain qualified investments, accounts, or other financial vehicles.
- Investors of different financial situations can benefit from tax-advantaged investments and accounts.
- Common examples include municipal bonds, 401(k) or 403(b) accounts, 529 plans, and certain types of partnerships.
- Tax-deferred status means that pre-tax income is used to fund an investment where taxes will be paid at a later date and at tax rates at that time.
- Tax-exempt status uses after-tax money to fund investments where gains or income produced by them are not subject to ordinary income tax.
Understanding Tax-Advantaged
Tax-advantaged investments and accounts are used by a wide variety of investors and employees in various financial situations. High-income taxpayers seek tax-free municipal-bond income, while employees save for retirement with IRAs and employer-sponsored retirement plans.
The two common methods that allow people to minimize their tax bills aretax-deferredandtax-exemptstatus. The key to deciding which, or if a combination of both, makes sense for you comes down to when the tax advantages are realized.
Tax-Deferred Accounts
Tax-deferred accounts allow you to realize immediatetax deductionson the full amount of your contribution, but future withdrawals from the account will be taxed at yourordinary-incomerate. The most common tax-deferred retirement accounts in the U.S. are traditional IRAsand401(k) plans. In Canada, the most common is aRegistered Retirement Savings Plan (RRSP).
Essentially, as the name of the account implies, taxes on income are deferred to a later date.
For example, if yourtaxable incomethis year is $50,000 and you contributed $3,000 to a tax-deferred account, you would pay tax on only $47,000. In 30 years, once you retire, if your taxable income is initially $40,000, but you decide to withdraw $4,000 from the account, taxable income would be bumped up to $44,000.
The SECURE Act made alterations to many of the rules related to tax-advantaged retirement plans and savings vehicles, like traditional IRAs and 529 accounts.
Tax-Exempt Accounts
Tax-exempt accounts, on the other hand, provide future tax benefits because withdrawals at retirement are not subject to taxes. Since contributions to the account are made with after-tax dollars, there is no immediate tax advantage.
The primary advantage of this type of structure is that investment returns grow tax-free. Popular tax-exempt accounts in the U.S. are theRoth IRAandRoth 401(k). In Canada, the most common is aTax-Free Savings Account (TFSA).
If you contributed $1,000 into a tax-exempt account today and the funds were invested in amutual fund, which provided a yearly 3% return, in 30 years the account would be valued at $2,427. By contrast, in a regular taxable investment portfolio where one would paycapital gains taxeson $1,427, if this investment were made through a tax-exempt account, growth would not be taxed.
With a tax-deferred account, taxes are paid in the future but with a tax-exempt account, taxes are paid right now. However, by shifting the period when you pay taxes and realizing tax-free investment growth, major advantages can be realized.
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Tax-Advantaged Investments
Tax-advantaged investments shelter some or all of an investor’s income from taxation, allowing them to minimize their tax burden. Municipal bond investors, for example, receive interest on their bonds for the duration of the bond’s life.
The proceeds from issuing these bonds to investors are used by municipal authorities to fund capital projects in the community. To incentivize more investors to purchase these bonds, the interest income received by investors is not taxed at the federal level. In many cases, if the bondholder resides in the same state where the bonds were issued, their interest income will also be exempt from state and local taxes.
Depreciation also yields tax advantages for individuals and businesses that invest in real estate. Depreciation is an income tax deduction that allows a taxpayer to recover the cost basis of certain property. In the U.S., the cost of acquiring a land or building is capitalized over a specified number of useful years by annual depreciation deductions.
For example, assume an investor purchases a property for $5 million (the cost basis). After five years, the investor has depreciation deductions of $500,000 and their new cost basis is $4.5 million. If they sell the property for $5.75 million, the investor's realized gain will be $5.75 million - $4.5 million = $1.25 million. The $500,000 deduction will be taxed at the depreciation recapture rate and the remaining $750,000 will be taxed as a capital gain.
Without the tax advantage of the depreciation allowance, the entire gain realized from the sale of the property will be taxed as a capital gain.
Tax-Advantaged Accounts
With regular brokerage accounts, the IRS taxes investors on any capital gains realized from selling profitable investments. However, tax-advantaged accounts allow an individual’s investing activities to be tax-deferred and, in some cases, tax-free. Traditional individual retirement accounts (IRAs) and 401(k) plans are examples of tax-deferred accounts in which earnings on investments are not taxed every year.
Instead, tax is deferred until the individual retires, at which point they can start making withdrawals from the account. Withdrawing from these accounts without penalty is allowed once the account holder turns 59½ years old.
Prior to the passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act, which was signed into law on December 20, 2019, once an account holder turned 70½ years, they were obligated to begin taking required minimum distributions (RMDs) from their tax-deferred retirement accounts. Under SECURE, individuals have until age 72 before the required minimum distributions kick in. In addition, the age limit for contributing to a traditional IRA was removed, allowing working account holders to invest indefinitely, similar to a Roth IRA.
The threshold to begin receiving distributions was changed once again when Congress approved and passed the SECURE Act 2.0 in December 2022. Individuals must begin taking RMDs when they turn 73 on or after Jan. 1, 2023.
What is Traditional IRA vs Roth IRA?
Traditional IRAs are tax-deferred investment vehicles, whereas Roth IRAs are tax-exempt. In the case of traditional IRAs, the amount you contribute gives an immediate tax advantage, as you can deduct this amount from your taxable income. While Roth IRAs provide no immediate tax advantage–you can not deduct contributions from your taxable income–the gains they accrue are tax-free upon withdrawal.
At What Age Does a Roth IRA Not Make Sense?
Individuals of any age can contribute to a Roth IRA. Unlike traditional IRAs, Roth IRAs do not have mandatory RMDs. However, Roth IRAs do have a five-year-rule, which requires individuals to wait five years following their first contribution to a Roth IRA to make their first earnings withdrawal. This limitation may be a factor to consider when deciding whether to contribute to a Roth IRA.
Should I Contribute to Roth or Traditional IRA First?
Whether you should contribute to a Roth IRA or a traditional IRA first depends on your future income expectations. If you expect your income to be lower at retirement than at the current moment, then you should focus your contributions toward traditional IRAs, which provide immediate tax advantages. However, if you expect your income, and thus tax rate, to be higher in the future, then consider contributing to Roth IRAs first, as future withdrawals from these accounts will be tax-free.
The Bottom Line
Roth IRAs and FSAs offer even more tax savings for investors than tax-deferred accounts, as activities in these accounts are exempt from tax. Withdrawals and earnings in these accounts are tax-free, providing a perfect example of a tax advantage.
Governments establish tax advantages to encourage private individuals to contribute money when it is considered to be in the public interest. Selecting the proper type of tax-advantaged accounts or investments depends on an investor's financial situation.
