A Beginner’s Guide to Tax-Advantaged Accounts
A tax-advantaged account could help lower your taxable income either now or later in life.
Contributing Writer at Tally
May 18, 2022
This article is provided for informational purposes only and is not to be construed as legal or tax advice. Consult with a professional financial or tax advisor before making tax decisions.
Every year, you must file a federal and state tax return. In the process of doing so, you’ll find out your tax bill for the previous year. Your tax bill is based on many things, including how much money you’ve earned at work, from your investments and through any other sources of income you may have.
One way to reduce your tax bill — either now or later in life — is to open a tax-advantaged account. As the name indicates, a tax-advantaged account is one that offers tax benefits.
In this article, we offer a beginner’s guide to tax-advantaged accounts. Specifically, we’ll go over what tax-advantaged accounts are, why they're beneficial and a few different types of accounts that you can consider using.
Tax-advantaged accounts: The basics
Simply put, a tax-advantaged account is one that offers you some sort of tax benefit. The two most common types of tax benefits are tax exemptions and tax deferments.
If you have a tax-exempt account, you do not have to pay taxes on the earnings. If you have a tax-deferred account, you do not have to pay taxes now but will have to pay them at a later date, such as when you make a withdrawal from your account.
Some common tax-advantaged accounts include:
Health Savings Accounts
It may seem obvious that gaining an advantage on your tax return is beneficial, but let’s take a closer look at why this is the case.
Why tax-advantaged accounts are beneficial
Tax-advantaged accounts are beneficial because they can reduce your income tax either now or in retirement.
There are different tax rates depending on how much you make. According to the IRS, the federal income tax brackets for 2022 for those single or married filing separately are as follows:
Incomes over $539,900: 37%
Incomes over $215,950: 35%
Incomes over $170,050: 32%
Incomes over $89,075: 24%
Incomes over $41,775: 22%
Incomes over $10,275: 12%
The tax brackets for those married filing jointly are:
Incomes over $647,850: 37%
Incomes over $431,900: 35%
Incomes over $340,100: 32%
Incomes over $178,150: 24%
Incomes over $83,550: 22%
Incomes over $20,550: 12%
The income limits listed above are based on adjusted gross incomes (AGI). Your AGI represents your taxable income after having considered deductions and exemptions.
When you have a tax-advantaged account, you reduce your AGI, either now or in the future. For instance, let’s say that you have a traditional individual retirement account, or traditional IRA for short. Traditional IRA contributions are made on a pretax basis. This means that they reduce your taxable income. Instead, you’ll pay taxes when you withdraw money from the account in retirement.
So, let’s say that your gross income is $45,000 and you decide to contribute $4,000 to a traditional IRA. You can take this $4,000 as a tax deduction to reduce your AGI. You’ll now pay taxes on $41,000 instead of $45,000.
(Also, as a quick note — this example is only representative of federal taxes. State tax rates and regulations can vary from state to state).
The other benefit that tax-advantaged accounts offer is that they could potentially reduce how much you’ll pay in taxes on your earnings. As mentioned, you will pay taxes when you withdraw money from your traditional IRA. Let’s say that you withdraw from the account in retirement when you are not earning as much money as you did during your working years. Your tax rate could be lower than it is now, which would ultimately save you money on taxes.
For example, let’s say you make $90,000 per year now and are in the 32% tax bracket. In retirement, if your income is lower, say, $45,000, you may be in a lower tax bracket. The gamble with this, of course, is that there is no way of knowing what the tax rates will be in the future. It may be worth your while to sit with a financial advisor to come up with a retirement plan that is based specifically on your personal finances.
Though everyone’s financial situation may vary, your advisor may recommend that you diversify your retirement savings across different types of tax-advantaged accounts. Diversification is an investment strategy that allows you to benefit from tax-advantaged accounts both now and in the future.
Different types of tax-advantaged accounts
When it comes to diversifying your tax-advantaged accounts, there are a few different types that you can consider. Below is a brief overview of some of the most common tax-advantaged accounts.
A traditional IRA is a type of investment account for retirement. For tax year 2022, the annual contribution limit for all IRAs is $6,000. For instance, you can have two traditional IRAs or a traditional IRA and a Roth IRA, as long as your total contributions across all accounts combined do not exceed $6,000.
As discussed previously, contributions are made on a pretax basis. Earnings grow tax-free, and you pay taxes when you withdraw the money.
Note that IRAs typically have early withdrawal penalties. If you withdraw from the account before the age of 59 1/2, you may have to pay a 10% penalty and income taxes.
Another type of IRA is the Roth IRA. The same contributions apply to a Roth IRA as they do a traditional IRA. However, there are annual income limits that also apply to a Roth IRA, depending on your tax-filing status.
Roth IRAs are attractive because earnings grow tax-free, and you do not pay taxes when you withdraw. However, contributions are made on a post-tax basis, meaning you will have paid taxes on the money you deposit into the account. But because you do not pay taxes on withdrawals, they won’t affect your tax bill in the future.
Note that like traditional IRAs, Roth IRAs typically have early withdrawal penalties. If you withdraw from the account before the age of 59 1/2, you may have to pay a 10% penalty and income taxes.
Health savings accounts (HSAs)
Another common tax-advantaged account option is a health savings account (HSA). HSAs are attractive because the money is tax-free when contributed, it grows tax-free and you can withdraw it tax-free. The only catch is that you need to use the funds for qualified medical expenses. The contribution limits for 2022 are $3,650 for individuals and $7,300 for families.
However, there is no time limit to submit for withdrawals. If you have an HSA, you should save receipts from your medical expenses. When you’re ready to make a tax-free withdrawal from your HSA, you can submit those receipts for reimbursement, no matter how many years after the health care expense you are submitting them.
If you withdraw funds for non-medical expenses, you will need to pay taxes. But as long as you use the HSA for health care expenses, it will not be a taxable account.
If one is available to you, you may want to consider an employer-sponsored 401(k), a type of retirement account. Your employer may offer a traditional 401(k) or a Roth 401(k). Like an IRA, a traditional 401(k) will reduce your taxable income in the year you contribute to it, while a Roth 401(k) will reduce your taxable income in retirement.
There are contribution limits with a 401(k). For 2022, the limit is $20,500. But anyone over 50 years old can make additional catch-up contributions of $6,500 as well.
One of the attractive features of a 401(k) is the potential for an employer match. Your employer may match a certain percentage of your contributions. Your employer match does not count toward your contribution limit. Essentially, it is free money that can grow in the account.
Note that 401(k)s typically have early withdrawal penalties. Like an IRA, if you withdraw from the account before the age of 59 1/2, you may have to pay a 10% penalty.
Using tax-advantaged accounts for retirement
A tax-advantaged account can be useful for retirement by reducing your future tax burden. For instance, let’s say that you put funds into a retirement savings account like a Roth 401(k). Both your principal and investment returns are not taxable when you withdraw the money in retirement. If you’re able to take a majority of your retirement income from this account, you will lower your overall tax bill considerably, since you will have minimal taxable income.
Using tax-advantaged accounts to build wealth
Tax-advantaged accounts can help reduce your tax bill, which can ultimately help you build wealth. Let’s say, for instance, that you were going to put a bit of money into a high-yield savings account. Instead, you route this to a traditional IRA.
You receive a tax break in doing so. Let’s say, as an example, that you reduce your tax bill from $5,000 to $4,500. The $500 that you save on taxes provides you with flexibility. Perhaps you could put this money toward debt. By paying down debt, you free up more cash and may open up more investment options. You were able to do this simply by taking advantage of a tax-efficient investment.
If you find yourself in a situation where you think you need to reduce your tax bill, you may want to consider speaking with a tax advisor. A tax advisor can evaluate your assets and determine areas where you can potentially save.
Tax-advantaged accounts can be a part of your financial management
When it comes to managing your personal finances, one thing that is easy to overlook is your tax dollars. There is nothing worse than receiving a bill from the IRS at the end of the year indicating that you owe money. You now have to scramble to find funds that may not have been in your budget otherwise.
One way to find tax savings is by using tax-advantaged accounts. Tax-advantaged accounts are those that offer benefits, typically either a tax exemption or a tax deferment. Using these accounts could reduce your AGI and lower your tax bill. You could also take advantage of these accounts to lower your tax bill in the future. There are different types of tax-advantaged accounts that you can consider using.
Not paying as much in taxes can free up cash elsewhere. For instance, you could put your tax savings toward your high-interest debt. If you have credit card debt that you’re looking to pay off, consider using Tally†. Tally is a credit card payoff app designed specifically to help you pay off debt with a lower-interest line of credit and manage your due dates.
†To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. The APR (which is the same as your interest rate) will be between 7.90% and 29.99% per year and will be based on your credit history. The APR will vary with the market based on the Prime Rate. Annual fees range from $0 - $300.