The power of tax-advantaged accounts
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When it comes to saving for the future, every penny can make a difference. And when you can save those pennies while also reducing your taxes, that's a win-win situation.
Tax-advantaged accounts allow you to not only save your money, but also put it to work for you by offering unique tax benefits.
Here are three types of tax-advantaged accounts your employer may provide:
Tax-deferred: This means that taxes on contributions, earnings, and gains are postponed until you withdraw the funds.
Tax-free: Your contributions, earnings, and gains are not subject to taxation, both while they are in the account and when they are withdrawn
Tax-deductible: Any contributions you make can be subtracted from taxable income, which reduces your taxable income
Different accounts come with different perks, and some may be available through your employer or an outside financial institution. Whatever mix of accounts you choose, the benefits they offer can put you on the path to long-term financial health.
Types of tax-advantaged accounts
1. 401(k)
You may have the option to contribute to a traditional 401(k) and/or a Roth 401(k) account sponsored by your employer.
In either case, employees can contribute a set amount of their income, and employers often match that amount up to a certain percentage. Then, the money gets invested and the account grows tax-free — which means there’s no tax on the interest your money accumulates over the years.
With a traditional 401(k), your contributions will be tax-deferred. In other words, you reduce your taxable income when you contribute, giving yourself a tax break upfront.
Once you make a withdrawal, however, the amount you take out will be taxed at whatever your current rate happens to be. If you’re younger than 59 ½ when you make a withdrawal, you may have to pay extra fees.
A Roth 401(k) is similar to a traditional account, but the conditions are reversed. With a Roth, your contributions are taxed along with the rest of your income, but your withdrawals are tax-free once you turn 59 ½ years old.
Choosing between the two accounts mostly comes down to when you’d rather pay taxes on your contributions. To learn more, visit our page on navigating the ins and outs of retirement accounts.
2. Individual Retirement Account (IRA)
While a 401(k) is opened through your employer, an IRA, or Individual Retirement Account, is opened independently through a broker or bank and allows you to make tax-deferred investments. 401(k)s and IRAs have a lot of similarities — and you can most certainly have both at the same time, but there are contribution and income limits that you’ll need to keep in mind.
Since these are independent accounts, you won’t be getting any extra contributions from your employer, and your annual contribution limit will be lower. But, you’ll have far more investment options to choose from.
In addition to traditional and Roth IRAs, you might also have access to a Simplified Employee Pension (SEP) IRA, a Savings Incentive Match Plan for Employees (SIMPLE) IRA, or an Inherited IRA.
3. Health Savings Account (HSA)
An HSA, or Health Savings Account, is a pre-tax account that’s reserved for qualified medical expenses.
You can only open an HSA if you’re on a High Deductible Health Plan, and your yearly contribution will be capped based on who your plan covers. Your HSA plan will come with a special debit card that you can use to pay for or reimburse qualified medical expenses — which can range from prescription medication to a new pair of running shoes.
The money you put in your HSA is yours to keep, even if you don’t use it in the same year you deposit it. In fact, it’ll even be around when you’re ready to retire, if you choose to keep saving.
You can grow your HSA tax-free by investing the money in stocks, bonds, mutual funds, and exchange-traded funds.
How does an HSA work?
Using your HSA for long-term savings
4. Flexible Spending Accounts (FSA)
Like HSAs, a Flexible Spending Account is an employee-sponsored account that’s used to pay for healthcare costs. Unlike HSAs, you can’t carry funds into the next year, and contribution limits also tend to be lower.
Since the funds in the account are use-it-or-lose-it, your FSA may offer two options for carrying over unused funds from one plan year to the next.
The first is a rollover limit that allows you to bring a certain dollar amount into the new plan year without counting toward your FSA contribution. You might also have a grace period, which extends up to 2.5 months into the next plan year for spending last year's funds. After that period of time, any remaining balance will go back to your employer.
In addition to a basic FSA, you might also have access to a few other types of accounts:
Limited Purpose Flexible Spending Account (LPFSA): An LPFSA is a type of FSA that allows you to set aside pre-tax dollars for eligible medical expenses — in this case, only vision and dental expenses. It’s often offered in conjunction with an HSA.
Dependent Care Flexible Spending Account (DCFSA): DCFSAs work in the same way, but can only be used for eligible dependent care expenses, like daycare, preschool, after-school programs, and even summer day camps.
Commuter Flexible Spending Account (Commuter FSA): Getting to work costs money. Some employers offer FSAs so you can use pre-tax dollars to cover transportation costs like public transit passes and parking fees.
How are an HSA and an FSA different?
5. 403(b) and 457(b)
If you work in the public, government, or nonprofit sector, there’s a chance you’ll get a 403(b) or 457(b) account instead of a 401(k). For employees, these accounts work exactly the same as 401(k)s, with pre-tax contributions and tax-free growth — but keep in mind that employer contributions aren’t always guaranteed.
While both 403(b)s and 457(b)s are similar accounts, there are a few small differences to keep in mind. Primarily, 457(b)s typically offer a broader range of investment options compared to 403(b)s, and they may also have higher contribution limits.
6. 529
These state-sponsored plans allow you to put savings into an investment account and select a beneficiary who can make withdrawals for qualifying expenses. They aren’t typically offered by employers, but you can always sign up for one through eligible banks and brokers.
There are two types of 529 plans to choose from.
Prepaid tuition plans: If you want your 529 account to be used solely for tuition costs, then this is the plan for you. A prepaid tuition plan allows you to pay in advance for some or all of the tuition at participating colleges and universities. You're essentially locking in the cost of tuition at today's rates, which can be a great way to hedge against future price increases and unpredictability.
Prepaid tuition plans are offered by certain states, and each state has its own unique features and benefits. These accounts do have limitations and restrictions, so it's important to thoroughly research and understand the terms of the plan before enrolling.
Savings plans: Similar to prepaid tuition plans, 529 savings plans can be used to pay for tuition, but they’re not limited there. Money can also go toward school fees, books, supplies, and room and board for college, as well as certain K-12 expenses. These accounts grow tax-free over time, so the sooner you open one, the more you can get down the line.
529 savings plans typically offer a range of investment options, so you can tailor your saving strategy based on your goals and timeline. The beneficiary of the plan can be changed at any time, and there are no income restrictions or age limits for contributions. You can even invite friends and family to contribute to the 529 savings plan!
7. Education Savings Account (ESA)
Good news: the similarities continue. ESAs operate much the same as 529s in that contributions grow tax-free and withdrawals for qualified education expenses are tax-free.
Unlike 529s, ESAs have a lower contribution limit and must be used by the time the beneficiary turns 30. ESAs also allow you a little more freedom to mix and match your investments, so you can blend your account with a mix of stocks, bonds, and mutual funds.
The benefits of tax-advantaged accounts
That was a lot of information thrown your way, but there are no more new acronyms to learn from here on out.
Now, whether or not you choose to open a tax-advantaged account is up to you, but there are some compelling benefits that go along with them.
Tax savings: Tax-advantaged accounts can help you keep more of your hard-earned money, which can add up to some pretty significant savings over time, especially if you're contributing on a regular basis.
Retirement savings: Fun fact: a lot of tax-advantaged accounts are designed specifically for retirement savings, like IRAs and 401(k)s. If you start investing in these plans while you’re still working, your money can work right alongside you, so you retire with a nice nest egg.
Employer matches: Many employee-sponsored accounts offer matches up to a certain percentage, which is basically like getting free money. Say you contribute 4% of your paycheck to your 401(k), and your employer matches up to that amount. You’re essentially doubling the amount of money in your account with each deposit.
Flexible use: While retirement is the most common purpose for tax-advantaged accounts, it’s far from the only use. Some accounts, like the 529 plans and ESAs we talked about above, can help you save on education expenses. Others, like HSAs and FSAs, can go towards health and wellness costs that would otherwise be out-of-pocket.
Chart your path to long-term financial wellness
If your employer offers tax-advantaged options, enrolling can help you help your money grow in the long term, but that’s just one piece of the financial wellness puzzle.
To make sure you’ve got the right financial tools for your future, you may want to consider opening independent accounts alongside whatever is available through your job to take your savings strategy to the next level.
And remember: you don’t have to figure this out on your own. Whether your employer offers financial advising services or you consult with a certified financial advisor, you’ve got resources to help you determine what the right mix of resources is for you. Here are two ways to get started:
Employer-sponsored accounts
Look into what your employer offers: First and foremost, find out what types of tax-advantaged accounts your employer offers. Common types include 401(k)s, HSAs, and FSAs, but you might consider asking about other options, as well.
Decide which accounts to open: Taking into account your financial goals and current/future needs, pick which accounts are best for you. You can even enlist the help of a financial consultant if you’re stumped. Often, consultations are free.
Sign up and choose your investments: Your employer should provide you with enrollment paperwork for the account you choose, so be sure to read all of the terms carefully. For retirement accounts in particular, you'll need to choose how to invest your contributions, ideally with a mix that matches your goals.
Set up contributions: Decide how much you want to contribute to your account each pay period, and set it up so that amount is automatically taken out of your paycheck.
Adjust as needed: Keep an eye on your account and make changes as you see fit, whether that’s switching up your investment mix over time or altering your contribution amount.
Independent accounts
Choose the type of account and provider: From IRAs to 529s, there are plenty of plans to choose from — narrow down what’s best for you based on your goals and timeline. You can then open an account at a bank, credit union, brokerage, or other financial institution that offers the type of account you want.
Sign up and make a deposit: Once you've chosen your financial institution, you'll need to fill out the necessary paperwork to open the account. This typically includes personal information such as your name, address, and Social Security number. Once your account is set up, you can choose how much you want to contribute, and even give your account a kick start by making a larger initial deposit.
Choose your investments: For certain accounts, you'll need to choose how to invest your contributions. Your financial institution should have a selection of investment options ready for you to review. If you don’t see the type of investment you’re looking for, be sure to ask about what else may be available.
Check-in as needed: Just like with your employer-sponsored accounts, be sure to drop by and visit your account periodically, making changes based on your preferences.
ALEX
Sometimes I miss the days when people used shells as currency, but then again, where are the pre-tax benefits in that system?