Putting away money for a child’s college education, a person’s retirement fund, or surprise medical expenses is always a good idea. However, using a standard savings or investment account to do so may not be the route that wealth management professionals would recommend.
Individuals can reap much greater benefits by contributing to a tax-advantaged account as part of their long-term financial planning. Not only does it help them save up for life’s biggest moments, but it’s also a key way to reduce their tax burden over their lifetime.
What is a tax-advantaged account?
A tax-advantaged account is a special-purpose savings account or investment plan that helps individuals save up for certain uses while minimizing their tax burden. This includes various retirement accounts, college savings plans, and more, which we’ll cover in more detail below.
These accounts may help people defer taxes and reduce their liability upfront, or offer other advantages like tax-free withdrawals down the line.
Each of these plans offers the dual benefit of helping contribute to savings goals while reducing overall tax liability.
Tax-deferred vs. tax-exempt accounts
The specific timing of benefits offered by a tax-advantaged plan can vary depending on whether it’s tax-deferred or tax-exempt.
A tax-deferred account allows individuals to fund the account with pre-tax income. This reduces their taxable income by the contribution amount in the current period and defers the tax liability until making a withdrawal in the future. This includes accounts like traditional IRAs or employer-sponsored 401(k)s.
A tax-exempt account does not lower taxable income when contributions are made. Instead, individuals are taxed on income earned in the current period, though the qualifying withdrawals on these accounts are tax-free. The money in these accounts essentially grows tax-free, which includes popular retirement accounts like Roth IRAs and Roth 401(k)s.
Types of tax-advantaged accounts
There are several types of tax-advantaged accounts, which vary in terms of structure, specific tax benefits, and contribution and withdrawal rules. Here is a closer look at the main types individuals can leverage in support of a tax planning strategy.
Retirement accounts: IRAs, 401(k)s, and other options
Traditional IRAs and 401(k)s are popular tax-deferred retirement plans in the United States. Workers make annual contributions to these investment accounts throughout their careers, which reduces their taxable income each year. Then, once in retirement, the withdrawals from these accounts are taxed at their ordinary income rate.
Roth IRAs and Roth 401(k)s are common tax-exempt retirement accounts. Workers pay all taxes on their income upfront, even the portion that they contribute to the retirement account. Then, they’ll enjoy tax-free withdrawals during retirement.
The IRS imposes contribution limits on these accounts, along with some other restrictions, though it tends to increase the limits each year to keep pace with inflation. For example, the annual limit for the 2024 tax year was $7,000 for those under age 50 and $8,000 for those over 50. For the tax year 2023, these limits were $6,500 and $7,500, respectively.
Health savings accounts (HSAs) and flexible spending accounts (FSAs)
Health savings accounts (HSAs) and flexible spending accounts (FSAs) are two types of tax-advantaged savings accounts. Contributions to these accounts can be made with pre-tax income, meaning they lower taxable income in the current year.
The unique aspect of these accounts is that qualified withdrawals may also be tax-free. Typically, qualifying payments include funds used on eligible health care expenses.
There are certain eligibility requirements to open these accounts, and contribution limits for each. With an HSA, for instance, the IRS indicates that individuals must be enrolled in a qualified high-deductible health plan, not be on Medicare, and not be claimed as a dependent by someone else.
Education savings accounts: 529 plans and Coverdell ESAs
Individuals can save up for college or other qualified educational expenses with a tax-advantaged 529 plan or Coverdell education savings accounts (ESAs).
Each plan has specific qualified uses, contribution limits, and tax benefits, making them better suited for different situations. However, both offer distinct tax advantages. Either plan enjoys tax-free withdrawals for eligible expenses. For 529 plans specifically, certain states may offer state tax deductions on contributions as well.
Benefits of tax-advantaged accounts
Based on the name, these accounts offer plenty of benefits when it comes to reducing an individual’s tax burden. However, there are other potential advantages that these accounts can offer.
Long-term savings growth through tax deferral
When setting aside funds in a tax-advantaged account, individuals can shift the period in which they pay taxes on investment earnings.
They’re able to contribute to the account each year, letting the balance grow over time. These investment earnings aren’t taxed each year when they’re earned, and are only owed when taken as a qualified withdrawal (for a tax-deferred account). In other words, the earnings are allowed to compound over time, potentially leading to a larger account balance.
Potential tax deductions and credits
Contributing to a tax-deferred account can help reduce the account holder’s taxable income in the current period. This offers a nice tax break during potential peak earning years. Keep in mind, this isn’t the case for tax-exempt accounts, which enjoy tax benefits when taking a qualified withdrawal.
In addition, certain accounts, like 529 plans, may offer tax credits or deductions at the state level, on top of tax-free withdrawals.
Strategies for maximizing tax advantages
Simply opening a tax-advantaged savings account or investment account may not provide the maximum benefits. Consider the following tips and suggestions to get the most out of these accounts.
Choose the right account for your financial goals
As special-purpose savings vehicles, tax-advantaged accounts can help people grow their savings for a specific use, be it college, retirement, or health spending.
Based on the individual’s circumstances and unique savings goals, people can choose the accounts that make the most sense for their overall tax strategy and financial needs. As an example, an adult couple without children may not have a practical need for education savings accounts, though FSAs, HSAs, and retirement accounts could fit into their tax and financial planning.
Max out contributions
As mentioned above, there are typically contribution limits regarding the amount that individuals can deposit into tax-advantaged accounts each year. The specific limits vary depending on the specific account. With an FSA, for instance, the contribution limit for 2025 is $3,300 of pre-tax income.
While savings goals can vary from person to person, it may be a strategic tax planning move to max out contributions to these accounts. This ensures the person takes full advantage of the available tax benefits while saving up for a specific need.
Plan withdrawals strategically
Depending on the specific account, there may be penalties associated with early withdrawals. With retirement accounts like 401(k)s, individuals generally need to have the account open for at least five years and wait until they’re 59½ to make withdrawals without a penalty. Otherwise, they’ll incur an additional 10% income tax on the withdrawn amount.
Individuals must carefully review the withdrawal rules associated with their specific account to avoid any financial penalties that diminish the tax advantages the account can provide.
Upgrading wealth management operations with BILL
Wealth management firms and family offices that offer tax planning services for clients may be seeking a better, more efficient way to support bill pay.
As a steward for clients’ finances, wealth management professionals could benefit from using a platform like BILL that streamlines this value-add service while keeping sensitive financial data secure.
Sign up for a free trial of BILL today to see how it can upgrade your wealthtech capabilities.
Frequently Asked Questions
What is meant by a tax-advantaged account?
Tax-advantaged accounts offer certain benefits that can lower your lifetime tax burden. On top of that, they are also used to support savings goals for certain purposes, like a child’s college education or retirement. Whether they offer immediate or delayed tax relief depends on the specific type of account, be it tax-deferred or tax-exempt.
What are the four main types of tax-advantaged retirement accounts?
The four main types of tax-advantaged retirement accounts include traditional IRAs and 401(k)s, which are tax-deferred accounts, and Roth IRAs and Roth 401(k)s, which are tax-exempt accounts. Each option offers different timing of tax benefits, and choosing between them requires careful consideration for the greatest impact.
What age should you start using tax-advantaged accounts?
Each person has their own savings goals. However, it’s usually a good idea to start contributing to these accounts as soon as possible. Where feasible, max out the allowed contributions to these accounts to take full advantage of the possible tax benefits.
What happens to tax-advantaged accounts after retirement?
During retirement, people can begin to withdraw funds from their tax-advantaged retirement accounts penalty-free (assuming they’re over 59½). If they have a tax-exempt account like a Roth IRA, the withdrawals will be tax-free. Withdrawals on a tax-deferred account, like a traditional IRA or 401(k), will be subject to income tax.
