You see, if you put your money in a traditional savings account, you’re going to pay taxes on its gains before you can touch it.
The reality is, you can take a massive hit on your investment as a result of taxes owed. “It is what it is,” as we all have to pay taxes.
Still, various approaches exist that can help you minimize the amount of tax owed, allowing you to benefit more from your hard-earned money.
When it comes to retirement savings plans, you should definitely consider tax-advantaged accounts. They’ll help you greatly reduce your tax bills.
What Are Tax-Advantaged Accounts?
Tax-advantaged accounts are financial or investment plans that offer tax benefits. These benefits are usually some relief in the form of tax exemption or tax deferral.
There are two categories of tax-advantaged accounts to consider when saving for retirement.
Tax-Deferred Investment Accounts
Tax-deferred accounts (or pre-tax accounts) defer taxation on your savings and investment interest. Up until a future date when you’re ready to withdraw.
After-Tax Investment Accounts
After-tax accounts offer tax benefits at a point in the future when you make withdrawals. This means that your investment and compound gains will be exempt from taxation, letting you keep your money in full.
Your tax-advantaged account only receives contributions that you’ve already paid income tax on.
Types of Tax-Advantaged Accounts for Retirement
Here’s a closer look at the top five kinds of accounts you should be considering for retirement planning:
Individual Retirement Arrangements
There are two types of individual retirement arrangements commonly known as IRAs. These are Traditional IRA and Roth IRA.
The traditional IRA is a tax-deferred savings account that allows tax deductions on your contributions annually. This lowers your taxable income.
Whatever earnings you may gain on your savings will remain untaxed until a later date. In this case, when you retire and withdraw your money.
Yet, a Roth IRA provides you with tax exemption both during the contributions and upon withdrawal. It means your money gets to grow tax-free, and you also get to keep all of it in the end.
Both types of IRAs share almost similar rules.
But, with Roth IRA, you won’t be eligible for tax deductions on your returns. It also has no RMDs, which means you can continue to keep money in your account past the age of 70 and a half.
401 (k) Accounts
Unlike IRAs, 401 (k)s are employer-sponsored. They are also the most common types of retirement plans.
The 401 (k) accounts come as both traditional and Roth.
Traditional 401 (k) allows employees to dedicate a cut from their tax-deferred income to the investment account. Taxes on a traditional 401 (k) account postpone until you withdraw the funds.
Keep in mind that traditional 401 (k) is subject to RMDs, which means you can’t postpone paying taxes on the funds past the age of 70.5 years.
With a Roth 401 (k) retirement plan, your contributions come after tax deduction. Meaning your retirement withdrawals and compounding interest are tax-free.
Note: If you’re receiving an employer match on your Roth plan, it’s going to be subject to tax upon retirement.
403 (b) Plans
A 403 (b) is a retirement plan offered to specific employees and is not available to everyone.
The main difference between a 403 (b) and a 401 (k) is that the former is only eligible to employees of certain not-for-profit or tax-exempt organizations.
Usually, public schools, churches, and certain tax-exempt organizations under Code Section 501 (c)(3) can set up 403 (b) plans for their employees. The employer may also offer matching contributions on behalf of the employees.
403 (b)s are tax-deferred, and employee funds are taxable once they leave the account. Still, much like a traditional 401 (k), you get to postpone tax payments until retirement.
You may want to consider 457 plans as special 401 (k)s designed for the employees of state and local governments. Some not-for-profit employers may also offer them.
The similarities between the 457 plan and the 401 (k) lie within taxing rules.
However, there are differences, such as early withdrawals that don’t attract a 10% penalty — unlike the 401 (k).
Employees under 457 plans may also contribute as much as 100% of their income, so long as it doesn’t exceed the yearly limit.
Another additional advantage is contributing to a 457 plan and a 403 (b) or a 401 (k). That is if your employer offers one or both alongside a 457 plan. You may contribute up to the maximum amount to both accounts.
Like the 401 (k) and the 403 (b), the 457 plan is taxable upon withdrawal.
Solo 401 (k)
The Solo 401 (k) is a retirement plan for self-employed individuals working by themselves. It’s also one of the best 401 (k) versions that anyone can open, provided they don’t have full-time employees.
The Solo plan rules are not that different from the 401 (k), but they do factor in both the employee and employer aspects of an individual venture.
But — the perks don’t end there.
One of the things that make the Solo 401 (k) an excellent retirement plan is that you decide the tax-advantage you want.
If you choose to go with a traditional Solo 401 (k), your contributions become pre-tax, meaning that your funds will be taxable upon retirement.
You also have the Roth Solo 401 (k) option. Which is hands down the best alternative as all your money and whatever the gains you made are tax-free when you withdraw.
other related articles of interest:
Tax-advantaged accounts should offer some relief, with the ultimate goal being a minimized tax burden.
They all come with various rules that may make one plan better than the other. This makes it crucial to consider your options carefully.
Do you have access to a tax-advantaged plan?
If you do, take advantage of it. It’s one of the best retirement resources one can have.
Image Credit: tax advantage accounts by envato.com
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