Tax-advantaged accounts: Types + wealth-building benefits

“Tax-advantaged” refers to financial assets and investments that provide a tax benefit. This includes tax-exempt Roth IRAs, tax-deferred 401(k) plans, and other tax-advantaged investment accounts. 

The average American taxpayer paid $14,279 in federal taxes alone in 2021, so every penny you can pinch for your own wallet counts. 

That’s the magic of tax-advantaged accounts. Whether you’re looking to build wealth through investments or save more for retirement, understanding your potential tax advantages is important. Explore types of tax-advantaged accounts, including eligibility and benefits below. 

What is a tax-advantaged account? Deferral vs. exemption

A tax-advantaged account is an asset that’s either tax-deferred or tax-exempt (also sometimes referred to as tax-free). 

Tax-deferred accounts delay your tax payment until distribution. This is most common with retirement plans like 401(k)s and IRAs.

The deferral reduces your current taxable income in the year you make the contribution, which is ideal while you’re working and earning income. You’re likely in a higher tax bracket now than you’ll be during retirement, so the current tax break is most valuable. 

Tax-exempt accounts are better for your overall wealth-building strategy. Now, these aren’t totally tax-free (depending on the investment) — you contribute after-tax funds to an account, and the earnings grow tax-free. 

Ideally, your investment performs well, compounds over time, and you can cash out without owing taxes. So while you pay typical taxes on your income now, your investment can grow exponentially without you owing another dime. 

Both types of tax advantages are valuable for most investors. You just have to know how to properly diversify your portfolio, and a financial advisor can help. 

Tax-advantaged retirement accounts

Retirement plans are some of the most popular tax-advantaged accounts, and they’re extremely valuable thanks to the long runway for investment growth. After all, if you start early, you can save for over 40 years before you reach retirement, which is a lot of compound growth.

Employer-provided plans, like your 401(k)

Employer-provided retirement plans are very common since they’re easy to enroll in and sometimes even automated. Many 9-to-5 workers have a 401(k), while nonprofit workers may have access to a 403(b) and government workers can use a 457 plan. 

The traditional versions of these accounts are tax-deferred — you won’t owe taxes until you retire and start distributions. You can also deduct pre-tax contributions from your current income. 

However, many plans also offer a Roth option. In this case, you pay taxes on your full income as usual, then your contribution goes to the Roth account. The money grows until retirement, when you withdraw it tax-free. 

Note that while Roth options are increasingly common with 401(k)s, you’ll want to confirm eligibility with your employer. 

Employer-provided 401(k)s, 403(b)s, and 457 plans have an annual contribution limit of $23,000.

IRA options

If you don’t have an employer plan or just want more control over your retirement, you can open an independently owned IRA. 

Like employer plans, you can choose between a traditional or Roth account, depending on whether you prefer pre-tax or after-tax contributions. 

But unlike employer plans, IRAs have more rules about who can contribute and receive tax deductions. The IRS sets modified adjusted gross income (MAGI) limits for these IRA benefits: 

• Pre-tax deductible contributions: You can’t fully deduct your traditional IRA contributions from your income if you exceed MAGI limits. However, you can still contribute after-tax funds to the account. 
• Roth IRA contributions: You can’t contribute directly to a Roth IRA if you exceed certain MAGI limits, period. 

There are some unique IRA benefits to enjoy, too. 

For one, contributions to a Roth IRA are available for penalty-free and tax-free withdrawals before age 59½. 

IRAs also have a wider selection of investment options than employer-sponsored plans. . 

However, traditional and Roth IRA contribution limits top out at $7,000 in 2024. 

Other tax-advantaged investments

Several tax-advantaged investments are available for wealth-building and other financial goals beyond retirement. To reduce your overall tax burden, check out these investment opportunities. 

Tax-advantaged education

College is expensive, and millions of young Americans are working to pay their monthly student loan payments. If you’re looking to reduce the burden for any future students in your life, the government has a few tax-advantaged investment options for you. 

First are 529 savings plans, also called “qualified tuition programs.” States provide these with some federal requirements, so eligibility and benefits can vary among programs. 

Contributions to 529 plans are tax-deductible, and earnings grow tax-free, giving you a mix of tax advantages. Though, you will owe taxes on distributions if you use the money on non-qualified education expenses. 

You can also check out Coverdell education savings accounts (ESAs), which provide tax-free distributions but no immediate tax deduction. There are federal eligibility requirements, so make sure you qualify. 

Both of these assets are primarily for higher education, but funds can also be used for primary and secondary education expenses. 

Health savings accounts (HSAs)

Health savings accounts (HSAs) are available to folks enrolled in a high-deductible health insurance plan to help cover the costs of care. You make pre-tax contributions to the account, and the investment grows tax-free until you withdraw (and distributions are also tax-free). 

The stickler: distributions can only be used on qualified medical expenses, otherwise you owe a 20% penalty, plus income taxes on the amount withdrawn. This is great for everything from your routine co-pays to stocking your medicine cabinet. 

But that triple tax advantage is hard to pass up, which is why people have started using HSAs as a supplemental retirement account. Once you reach age 65, you can use the money for nonmedical expenses and you’ll only owe taxes, not an additional penalty.  

Municipal bonds

Municipal bonds work like a loan, except you’re the lender, and the municipality is the borrower/bond issuer. Because smaller government entities provide them, they’re one of the safest investments available (though you should still do your research).

They’re also exempt from federal taxes since the government doesn’t typically tax state activity. 

Depending on the bond, you might not owe state taxes, either. Though, it depends on the bond and your residence. Your state might want a tax share on any earnings from an out-of-state bond. 

Municipal bonds are great because they’re secure and tax-exempt, but gains are relatively small compared to riskier investments. They’re still a great way to hedge against fluctuating investments and reduce your portfolio risk. 

Tips to make the most of your investments

We’ve covered several tax-advantaged accounts and a few benefits of each, so now where do you start?

Here’s our advice to reduce your tax liability without sacrificing your wealth. 

Kickstart your retirement savings

Retirement is a long-term game, so the sooner you start investing, the better. If you have an employer-provided plan, start there. 

A 401(k) is most common, so decide if a traditional or Roth account is right for you. 

• Pre-tax traditional contributions are best when you’re established in your career, and the deduction can boost your contributions and lower your tax bracket. 
• After-tax Roth contributions are usually best when you’re early in your career and expect your income to rise. WIth a lower tax bracket,  tax-exempt status can give you a better lifetime benefit. 

If you have an employer-match benefit, your first retirement goal should be to max out that contribution. 

Then, you can continue to contribute to your employer plan or opt for an IRA. These have a separate contribution limit, so you can squirrel away more money each year. You also have a little more investment flexibility to customize your portfolio.

Grow wealth with tax-exempt accounts

Most tax-exempt accounts are for retirement and education, so they’re not exactly making you rich. Tax-exempt investments like municipal bonds and Roth IRA contributions are better for liquid net worth gains. 

Yeah, you’ll pay your taxes upfront — that can be a bummer if you’re a high earner. But you’ll appreciate the delayed gratification when you cash out without owing a dime. 

This is especially valuable with the compound, long-term growth like Roth IRAs offer. A couple thousand dollars a year can grow into hundreds of thousands within a few decades, and it’s all yours to keep. 

However, you might have to get creative with your contributions if you’re a high earner. You can’t contribute to a Roth IRA directly, but you can work with an advisor to execute a backdoor Roth. 

Be smart about your portfolio mix

Most investors will benefit from a mix of tax-deferred and tax-exempt accounts, and the exact balance you want will likely evolve over time. 

Keep an eye on your portfolio and ensure it still aligns with your goals, including:

• Risk: Younger investors can recover from losses easier than older investors counting down to retirement. 
• Asset allocation: Portfolios typically consist of bonds, stocks, and cash — work with an advisor to determine which mix works for you. 
• Tax advantages: Tax priorities depend on your income and investment goals. Deferrals are great if you’re a high earner looking to reduce your current tax burden, while exempt accounts can reduce your tax bill in retirement. 
• Gains: Part of determining your tax advantages is also looking at your investment performance. You don’t want all of your best-growing stocks in tax-deferred accounts where you’ll owe a huge tax bill at distribution. 

This may not be straightforward for new investors, so chatting with a professional is a good idea. You can consult robo-advisors or other advisors to align on goals and strategies. 

The Playbook take: Mix and match tax advantages to safeguard your income

You can’t avoid taxes altogether, but you definitely don’t have to pay the full bill, either. If you understand tax-advantaged accounts and their benefits, you can build a portfolio that maximizes your wealth building while slashing your taxes now or in the future. 

Want to see what tax advantages you’re missing out on? Get a personalized financial roadmap from Playbook and see where you can save.