While you can save money in a brokerage account or general savings account, opting for those options can be costly mistakes for some people. Several types of tax-advantaged accounts may be available to you that can help you more effectively save and invest.
If you are planning for your retirement, saving for your child’s education, or need to set aside money for health expenses, here is what you need to know about tax-advantaged accounts.
What is a tax-advantaged account?
A tax-advantaged account is an investment or financial account that is either exempt from taxes, defers taxes, or has other benefits. By taking advantage of tax-advantaged accounts, you can save for your future goals while minimizing your tax bill.
There are two main forms of tax-advantaged accounts:
- Tax-deferred: With a deferred account, you don’t have to pay taxes on your earnings or contributions until you start making withdrawals from the account, usually in your retirement.
- Tax-exempt: Tax-exempt accounts provide future benefits. You pay taxes on your contributions, but you can make withdrawals tax-free later.
10 Types of Tax-Advantage Accounts
There are many different kinds of tax-advantaged accounts. Depending on your goals, you may decide to open one or more of the following accounts:
1. 401(k): Retirement
A 401(k) is one of the most well-known tools for retirement savings. A 401(k) is an employer-sponsored retirement plan that allows employees to contribute money on a pre-tax basis. Your contributions and earnings are not taxed until you start making withdrawals.
For 2021, the maximum you can contribute to a 401(k) is $19,500 per year. Employees 50 and older can contribute an additional $6,500 per year. Some companies will even match a certain percentage of your contribution, which is a great way to add to your savings.
2. 403(b): Retirement
Like 401(k) accounts, a 403(b) is a form of an employer-sponsored retirement account. If you work for a public school, university, or non-profit organization, you may be eligible for a 403(b) account.
With a 403(b), you make contributions before taxes are taken out of your paycheck. You don’t pay taxes on the contributions or earnings until you start making withdrawals.
The maximum amount you can contribute to a 403(b) in 2021 is the lesser of 100% of your compensation or $19,500 per year. An employee who is 50 or older can take advantage of catch-up contributions and contribute an additional $6,500 per year into their account.
3. 457(b): Retirement
A 457(b) is a tax-deferred retirement plan offered by state and local government agencies and some non-profit organizations. You contribute pre-tax money from your paycheck and don’t start paying taxes on contributions or earnings until you make withdrawals.
With a 457(b), the maximum you can contribute is $19,500 per year. However, participants that have three years until retirement age can make additional contributions. They can contribute up to twice the annual limit for 2021.
4. Traditional IRA: Retirement
With a Traditional Individual Retirement Account (IRA), your contributions are usually tax-deductible. They are also tax-deferred, so you pay no taxes on your IRA’s earnings until you make withdrawals from your account.
You can contribute up to $6,000 per year into a Traditional IRA. If you are 50 or older, you can make a $1,000 additional catch-up contribution.
5. ROTH IRA: Retirement
A Roth IRA works differently than a Traditional IRA. Your contributions are not tax-deductible, and you make contributions with after-tax dollars. However, Roth IRAs offer a unique advantage: your earnings and withdrawals are tax-free.
Roth IRAs have the same contribution limits as Traditional IRAs.
6. 529 Plan: Education
A 529 education savings plan is a tool you can use to save for your child’s college tuition and fees. The money you invest can grow over time, and if the money is withdrawn to pay for qualified educational expenses, earnings are not subject to federal income tax. Depending on your state, your contributions may also be tax-deductible.
While 529 plans do not have contribution limits, contributions toward a 529 plan count as gifts and are subject to gift-tax laws. The annual limit for 2021 is $15,000.
7. Coverdell Education Savings Account: Education
A Coverdell education savings account is another tool you can use to save for your child’s education. With a Coverdell, contributions are not tax-deductible. However, distributions used to pay for educational expenses are tax-free.
Contributions to a Coverdell account cannot exceed $2,000 per year.
8. UGMA/UTMA account: Education
With a UGMA/UTMA, you can save money and invest on behalf of a minor. Once the child reaches a certain age, the fund is transferred into their name to use as they wish. Money placed into the account is owned by the child, so earnings are generally taxed at a much lower rate.
9. Health Savings Accounts: Health
A health savings account (HSA) allows you to save money on a pre-tax basis for qualified medical expenses. You can use the money in the account to cover your deductibles, coinsurance, copay, and other expenses.
HSAs have three tax benefits. You make contributions with pre-tax dollars, and your earnings are tax-free. Plus, you don’t pay any federal income taxes on your withdrawals when the money is used for qualified medical expenses.
Only available to people enrolled in a high-deductible health plan (HDHP), you can contribute up to $3,550 per year into an HSA with self-only coverage. If you have money left in the account at the end of the year, it will roll over into the next year.
10. Flexible Spending Accounts: Health
Some employer-offered health insurance plans include flexible spending accounts (FSAs). With an FSA, you make pre-tax contributions into a separate account to use for health expenses. You can use your FSA dollars to purchase prescription and over-the-counter medications, pay your deductibles or coinsurance, and purchase medical supplies.
For 2021, the contribution limit for FSAs is $2,750 per year. You must use all of the funds in your account by the end of the plan year or risk losing the money.
Choosing tax-advantaged accounts
Utilizing tax-advantaged accounts can help you reduce your taxable income while investing for future goals. By using tax-exempt or tax-deferred accounts, you can grow your savings and use your money more efficiently.
If you’re not sure which kind of account is best for you, meet with a certified financial advisor to discuss your plans.
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Information contained in this blog is for educational and informational purposes only. Nothing contained in this blog should be construed as legal or tax advice. An attorney or tax advisor should be consulted for advice on specific issues.