Tax-advantaged accounts were created by the government to encourage you to save for critical, societally-beneficial goals like retirement, medical care, and education. They achieve this by offering powerful tax advantages that fundamentally shift when you pay taxes on your money. Tax-advantaged accounts typically offer some combination of three core tax advantages, as outlined below, though no single account bestows all three simultaneously (at least not without limitations).
🐖 Advantage #1: Tax-Deductible Contributions
How it Works: Accounts with this advantage allow income to be contributed to the account before income taxes are paid, typically via pre-tax salary deferrals from your paycheck. The amount you contribute is subtracted from your taxable income for the year, reducing your tax bill in April.
The Benefit: By allowing you to contribute money before it is taxed, the government is essentially allowing you to invest the money you would have otherwise paid in taxes. While this pre-tax money will eventually get taxed, the larger starting principal can be invested in the meantime, allowing you to pocket the growth.
🚀 Advantage #2: Tax-Deferred Growth
How it Works: Accounts with this advantage allow investment income within the account (interest, dividends, and realized capital gains) to avoid being taxed as it accumulates. This is in contrast to a taxable brokerage account, where you are required to pay taxes on this investment income annually, inducing a tax drag on the account over time.
The Benefit: By deferring the taxation of the account’s investment income, the full value of that income is allowed to continue to grow and compound over time. Similar to the prior benefit, this untaxed income will eventually be taxed, but in the meantime you can keep those deferred taxes invested and pocket the growth.
🏧 Advantage #3. Tax-Free Withdrawals
How it Works: Accounts with this advantage allow you to withdraw funds from the account – both the original contributions and all the accumulated investment growth – without those funds being subject to federal income tax. This is typically because the contributions to these accounts were made with after-tax dollars.
The Benefit: Because the money in the account can be withdrawn tax-free, the full value of the account is yours to keep, insulating you from potentially higher tax rates later in life. This is in contrast to accounts with pre-tax money in them, where some unknown but often sizable fraction of the account balance will eventually be paid to the IRS. Furthermore, tax-free withdrawals do not increase your taxable income in retirement, which can help minimize taxes on Social Security benefits and reduce the cost of Medicare premiums.
Which account types have which advantages?
The following table maps the three tax advantages above to the most common types of tax-advantaged accounts:
Account Type | 🐖 Tax-Deductible Contributions | 🚀 Tax-Deferred Growth | 🏧 Tax-Free Withdrawals |
|---|---|---|---|
Baseline Account Type (for comparison) | |||
Taxable Brokerage Account | ❌ No – contributions are made with after-tax dollars. | ❌ No – investment income (interest, dividends, capital gains) is taxed annually. | ❌ Not really – while the withdrawals themselves are not taxed, the sale of investments within the account to fund the withdrawals will typically generate capital gains that are taxed. |
Employer-Sponsored Accounts | |||
Traditional 401k (403b, 457b) | ✅ Yes | ✅ Yes | ❌ No – withdrawals are fully taxed as ordinary income. |
Roth 401k (403b, 457b) | ❌ No – contributions are made with after-tax dollars. | ✅ Yes | ✅ Yes |
Individual Accounts | |||
Traditional IRA | ✅ Yes – as long as your income is below certain thresholds. | ✅ Yes | ❌ No – withdrawals are fully taxed as ordinary income. |
Roth IRA | ❌ No – contributions are made with after-tax dollars. | ✅ Yes | ✅ Yes |
Health Savings Account (HSA) | ✅ Yes | ✅ Yes | ✅ Yes – for qualified medical expenses. |
529 Education Plan | ❌ Not federally – contributions are made with after-tax dollars – but states typically offer state deductions or credits. | ✅ Yes | ✅ Yes – for qualified education expenses. |
What limitations come with tax-advantaged accounts?
Tax-advantaged accounts supercharge your savings by shifting how and when the funds in the account are taxed. However, these tax advantages come with significant limitations that restrict how the accounts are funded, accessed and controlled. Understanding these limitations is key to getting the most out of tax-advantaged accounts and avoiding costly mistakes.
