What is Tax-Advantage?

Types of Tax-Advantage Accounts

  • Pre-Tax Investment Accounts (Deferred Tax): These investments delay your taxes for a later date in the future until the investment provides gains and funds are withdrawn from investments.After-Tax Investment Accounts: The tax you already paid contributes to this account. Gains/earnings from these accounts will not have any taxes applicable up to a certain limit.

#1 – Pre-Tax Accounts

In the U.S Traditional 401(k), 403(b), and 457(b) are mostly used employer-sponsored saving plans; most of these plans are funded by an employee, while certain employers provide a matching contribution in these accounts.

  • Most business organizations offer this plan. The employee selects their contribution up to certain limits with various investment options, mainly based on the tax-deferred principle. Some employers also contribute a matching amount to this fund. Yearly employees can contribute up to $19,000 to this account, while employees above 50 can contribute an additional $6,000.The amount of employees invested in this account is safe even if the employee leaves an organization; upon new employment, the employee will have the option of switching or staying with the old plan. Up to the age of 70, an individual can eventually invest and keep their money in these accounts after they need to withdraw and pay taxes on their earningsEarningEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments.read more as regular income.

Especially for employees from non-profit organizations, universities, schools, religious organizations, hospitals, etc.; Tax rules and contributions remain the same as the 401(k) plan.

Local and state government employees can invest in a 457 plan, similar to 401(k) for contribution limits and tax rules. Still, they do provide some additional tax benefitsTax BenefitsTax benefits refer to the credit that a business receives on its tax liability for complying with a norm proposed by the government. The advantage is either credited back to the company after paying its regular taxation amount or deducted when paying the tax liability in the first place.read more.

  • Double contribution in case employers offer 403(b) when you don’t have more than three years for your retirement age;If the employer offers all three mentioned plans, then your investment contribution in this tax-deferred account can be doubled, i.e., $38000 or $50000 (for individuals above 50 years).Early withdrawals before age 59.5 are subject to taxes, but the penalty is not applicable to this investment account.

Traditional Individual Retirement Arrangement: Under this account, the contribution from an individual’s income is deductible. In case the employer of an individual offers an employer-sponsored plan and the income of an individual crosses the limit of modified adjusted gross incomeAdjusted Gross IncomeAdjusted Gross Income (AGI) is calculated from the gross income. It represents the net income earned by an individual in a year, including wages, capital gains, and retirement distributions after deducting above-the-line deductions. It determines an individual’s taxable income by determining deductions or credits a person is eligible to receive.read more, contribution in this plan may not be allowed for tax deductions.

All the above plans are considered with a point of view that when an individual retires and withdraws their investments, they will be in the lower-income group compared to the time they were in employment, which gives them tax benefits at a future date when they retire.

#2 – After-Tax Retirement Savings Account

An account funded with income after tax is a Roth account. Select this option for people who expect higher tax at retirement compared to the time of employment.

  • Roth 401(k), 403(b), 457 Plans: Same as a tax-deferred option, an employer might also provide an after-tax investment option. According to these options, individuals will not benefit from contributing to these plans. Still, they will receive a tax-free distribution on withdrawal after five years or after the age 0f 59.5. Employer contribution will come under traditional plans, and a minimum distribution will be required for an individual over age 70.Roth Individual Retirement Arrangements: Roth IRA does not provide tax deductions, but qualified tax-free distributions are available.

You are free to use this image on you website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be HyperlinkedFor eg:Source: Tax-Advantage (wallstreetmojo.com)

Other Tax Advantage Saving Plans

College/education saving plans

  • 529 plan: Withdrawals are tax-free, but contributions can be decided by the individual, whether tax-deferred or after-tax.Coverdell education saving account: contribution can be made depending on a tax-deferred or after-tax basis; available withdrawals are tax-free but should be used before the child of an individual turns 30.

Importance

  • Promotes Investments: Proper investment using tax-advantaged funds will not just provide benefits in terms of taxes but also promote investment strategies for individuals.Multiple Strategies: There are multiple strategies for tax advantage accounts available, depending on the individual’s goals and financial condition. They can decide which is more suitable for them.Future Planning: Individual plans their investment for a future time like retirement, family, child education, healthcare, wealth planning, etc. Such accounts provide an overview and help to decide which strategy every individual should adopt.Reduce Tax Burden: These investments help reduce the tax burden with various strategies, from tax-deferred to after-tax investments. E.g., Government bonds.

Tax-Advantaged vs. Tax-Deferred

Conclusion

  • Tax planning is an important part of an investment since part of your income you pay to the government as taxes. Whether to choose from tax-deferred or after-tax investment depends completely on individuals’ decision to pay taxes at the time of earning or at the time of withdrawals; However, tax-saving today is better, and the benefits of receiving tax-free withdrawals in the future at cost after-tax investment are very high because of investment size.Tax advantage plans benefit all categories of individuals from various income groups. Individuals make decisions based on future financial goals, family requirements, health expenses, educational expenses for children, and wealth creation over a period. Utilizing both types of tax-advantaged strategies will provide flexibility and benefits.

This has been a guide to What is Tax-Advantage & its Definition. Here we discuss the top 2 tax advantages and importance and the difference Between tax-advantage vs. tax-deferred. You can learn more about it from the following articles –

  • Tax EvasionTax-Sheltered AnnuityTax ReformWindfall Tax