The benefits of tax-efficient wealth management.
A tax-advantaged account offers certain tax benefits to encourage individuals to save or invest for specific purposes, such as retirement, education or healthcare. These accounts can help you lower your taxable income, defer taxes or avoid taxes altogether if used for qualified expenses.
Beyond tax efficiencies, tax-advantaged accounts also offer estate planning benefits, access to a variety of investment options, coverage for future medical and education expenses and potentially simpler tax reporting.
Types of tax-advantaged accounts
Retirement plans
There are several tax-advantaged account options, each with its own benefits and rules:
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401(k) plans are employer-sponsored plans that allow employees to contribute a portion of your salary to the plan on a pre-tax basis. Your employer may also match a portion of the money you contribute. Contributions and investment gains within a 401(k) plan are tax-deferred until withdrawn.
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Traditional Individual Retirement Accounts (IRAs) allow you to contribute a certain amount on a yearly basis. Contributions may be tax deductible, but like 401(k) plans, investment gains are tax-deferred until they’re withdrawn.
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Roth IRAs are individual retirement accounts that allow you contribute a certain amount each year with after-tax dollars. Roth IRAs don’t have required minimum distributions (RMDs) and any qualified withdrawals are tax-free, including both contributions and earnings. (Tax-free and penalty-free withdrawals can be made after the age of 59½, and once the account has been open for a minimum of five years.)
Rules and benefits vary from account to account and depend on your tax situation as well as any future changes in tax laws. Tax-deferred retirement accounts allow you to put off paying taxes upfront, which means you have to pay at the point any money is withdrawn.
Education plans
529 plans are specifically designed to help families save for future eligible education expenses, such as tuition, fees, books and certain living costs. These plans create a tax-advantaged account where you can save money earmarked for education expenses. You can contribute post-tax funds to this account, and when it comes time to cover qualifying educational costs, you won’t be obligated to pay federal taxes on the money withdrawn.
The two primary types of 529 plans:
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College savings plans allow you to invest in a variety of investment options, such as mutual funds, certificates of deposit (CDs) and money market funds. Over time and based on the performance of the investments you choose, the value of your account will fluctuate.
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Prepaid tuition plans give you the opportunity to prepay tuition at eligible colleges at today’s prices, helping you lock in tuition costs and avoid future price increases. Aside from tuition, withdrawals from these plans can also be used for various qualified expenses like room and board.
Coverdell Education Savings Accounts (ESAs) is another education plan option that works similarly. While the money used to fund these types of accounts isn’t tax-deductible, you’ll enjoy tax savings on any money you make on your investments.
The key difference between 529 plans and Coverdell ESAs is that a Coverdell ESA has a lower annual contribution limit per beneficiary and can be used to cover a range of qualified education expenses for both college and K-12 expenses. Coverdell’s offer a more flexible investment universe, including individual securities, like stocks and bonds.
Health plans
There are two main types of tax-advantage health plans:
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Health Savings Accounts (HSAs) are tax-advantaged savings accounts that allow you to save for qualified medical expenses. HSAs require you to be enrolled in a high-deductible health plan. Interest earned within an HSA is tax-deferred, allowing investments to grow without being taxed until withdrawn. However, HSA withdrawals are tax-free providing they’re used for eligible medical expenses.
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Flexible Spending Accounts (FSAs) are employer-sponsored accounts that allow employees to set aside pre-tax dollars for qualified medical expenses or dependent care expenses like deductibles and copayments. Contributing to an FSA can reduce your taxable income from your gross salary before taxes are withheld.
Not only can health-related tax-advantage accounts help you cover future medical expenses, but they can also be used as a long-term and diversified savings vehicle to help you plan for the future.
Please note, changes in tax laws may occur at any time and could have a substantial impact upon each person's situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of Raymond James, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.
Contributions to a traditional IRA may be tax-deductible depending on the taxpayer’s income, tax-filing status, and other factors. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty.
Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted.
401(k) plans are long-term retirement savings vehicles. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty.
Investors should consider, before investing, whether the investor’s or the designated beneficiary’s home state offers any tax or other benefits that are only available for investment in such state’s 529 savings plan. Such benefits include financial aid, scholarship funds, and protection from creditors.
As with other investments, there are generally fees and expenses associated with participation in a 529 plan. There is also a risk that these plans may lose money or not perform well enough to cover education costs as anticipated. Most states offer their own 529 programs, which may provide advantages and benefits exclusively for their residents. The tax implications can vary significantly from state to state.
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