The Advantages of Tax-Advantaged Accounts

Tax-advantaged accounts provide a tax benefit for your investments, unlike the taxable account types we discussed last week. The main advantage is the ability to grow your investment earnings without being taxed until they are withdrawn in the future (or in some cases your investments might not be taxed at all). This is referred to as tax deferral (or tax exemption).

Utilizing tax-advantaged accounts can help your portfolio grow faster and more efficiently over time. For example, say you have two accounts, each starting with $100,000, but one is taxable and one is tax deferred. Each account grows 10% per year for 20 years. The only difference is the taxable account is required to pay 20% taxes on its earnings each year while the tax deferred account will pay a 20% lump sum tax in the final year (assuming the entire account is withdrawn).

As you can see, deferring taxes can create a major benefit over the long-run. Even after withdrawing all of the money in the end and paying a large lump sum in taxes, the tax deferred account ends up with a higher value than the taxable account by about $57,000. Over the 20 year period, this equates to an additional 2.4% per year benefit for the tax deferred account!

This is a simplified example and more planning would need to be done to optimize the tax advantages (you would most likely not withdraw all of the money right away at the end, you could include tax exempt accounts, etc). However, it displays the value that can be added from utilizing tax-advantaged accounts.

There are many tax-advantaged accounts to choose from. Here are some characteristics of the most common account types:

401(k)

• Who it’s for – This is most commonly found in companies with numerous employees (20+).
• Who makes the contributions – Employees can contribute through salary deferrals while employers can match a percentage of your contributions, make non-elective contributions, or provide profit-sharing contributions.
• Annual contribution limits – Employees age 49 and under can contribute $19,500. Employees age 50 and older can contribute $26,000. Your employer can also contribute up to $57,000 (however, combined employee and employer contributions cannot exceed $57,000 total).
• Income limits for participation – There are no income limits.
• Distributions – Distributions are taxable at your normal income tax rate. If you withdraw funds prior to age 59½ (outside of certain exceptions), there is an additional 10% penalty. You are required to begin taking distributions (RMDs) once you reach age 72 unless you are still working.

Traditional IRA

• Who it’s for – Individuals who are looking to save extra money in a tax-advantaged manner.
• Who makes the contributions – You make all contributions. To do this, you must have employment compensation. However, you are permitted to contribute for a non-working spouse.
• Annual contribution limits – Individuals age 49 and under can contribute $6,000. Individuals age 50 and older can contribute $7,000. 
• Income limits for participation – There are no upper income limits for making contributions, but you must have earned income of at least the amount you contribute for the year. However, there are phase out limits for receiving a tax deduction on the contributions.
• Distributions – Distributions are taxable at your normal income tax rate. If you withdraw funds prior to age 59½ (outside of certain exceptions), there is an additional 10% penalty. You are required to begin taking distributions (RMDs) once you reach age 72, regardless if you are still working or not.

Roth IRA

• Who it’s for – Individuals who are looking to save extra money in a tax-advantaged manner.
• Who makes the contributions – You make all contributions. To do this, you must have employment compensation. However, you are permitted to contribute for a non-working spouse.
• Annual contribution limits – Individuals age 49 and under can contribute $6,000. Individuals age 50 and older can contribute $7,000. 
• Income limits for participation – There are income phase out limits for making contributions, and you must have earned income of at least the amount you contribute for the year. 
• Distributions – Distributions are tax free, as your contributions are made after taxes. There can be a 10% penalty on withdrawals prior to age 59½ and the account being open less than 5 years. However, this only applies to gains in the account (your original contributions can always be withdrawn without penalty as you have already paid taxes on this money). There are no required distributions (RMDs).

Annuities

• Who it’s for – Individuals who are looking to save extra money in a tax-advantaged manner.
• Who makes the contributions – You make all contributions. There are no compensation requirements (funds can come from other investments, etc). 
• Annual contribution limits – There are no contribution limits.
• Income limits for participation – There are no income limits.
• Distributions – If you have a “qualified account” distributions are similar to a Traditional IRA (distributions are taxable, subject to a 10% early withdrawal penalty prior to age 59½, and RMDs are required at age 72). “Non qualified” annuity withdrawals are a mixture of tax-free contributions and taxable earnings. There may also be surrender charges if money is withdrawn before a specified surrender period is over.

When determining what account type is best for you, there are many factors to consider. Oftentimes, having a mixture of taxable, tax deferred, and tax exempt accounts can be beneficial as it allows you to maintain flexibility when taking withdrawals. Proper asset location can be key to maximizing your portfolio value, and tax-advantaged accounts can play a major role.

Derek Prusa, CFA, CFP® and Ben Webster, CFP®

Co-Founders and Owners of Aspire Wealth