Tax-Advantaged

Tax-Advantaged Accounts: Maximize Savings and Reduce Taxes

Tax-advantaged accounts and investments offer meaningful tax benefits that help investors grow wealth and lower tax liability. They generally fall into two categories: tax-deferred (taxes paid later) and tax-exempt (tax-free growth and withdrawals). Knowing the difference and how each works can help you choose the right vehicles for retirement and other goals.

Key takeaways

• Tax-advantaged accounts either defer taxes until withdrawal or allow tax-free growth and withdrawals.
• Tax-deferred examples: traditional IRAs, 401(k)s, RRSPs — contributions may be tax-deductible and withdrawals are taxed as ordinary income.
• Tax-exempt examples: Roth IRAs, Roth 401(k)s, TFSAs — contributions are made with after-tax dollars but qualified withdrawals are tax-free.
• Certain investments, like municipal bonds and real estate depreciation, also offer tax benefits.
• Recent law changes (SECURE Act and SECURE Act 2.0) have adjusted required minimum distribution (RMD) ages; staying current on rules is important.

How tax-advantaged accounts work

Investors use tax-advantaged accounts to time their tax liabilities and shelter investment growth.

Tax-deferred accounts
* Contributions are often tax-deductible, reducing taxable income in the contribution year.
* Earnings grow tax-deferred; withdrawals are taxed as ordinary income.
* Example: If your taxable income is $50,000 and you contribute $3,000 to a tax-deferred account, you’re taxed on $47,000 that year. Withdrawals in retirement are then taxed.

Common tax-deferred vehicles: traditional IRA, 401(k), RRSP (Canada).

Tax-exempt accounts
* Contributions are made with after-tax dollars; there’s no upfront deduction.
* Earnings and qualified withdrawals are tax-free.
* Example: $1,000 invested at 3% annually grows to about $2,427 in 30 years — in a tax-exempt account that growth wouldn’t be taxed.

Common tax-exempt vehicles: Roth IRA, Roth 401(k), TFSA (Canada).

Tax-advantaged investments (outside retirement accounts)

• Municipal bonds: Interest from many municipal bonds is exempt from federal income tax, and often state/local tax if you live in the issuing state.
• Real estate depreciation: Depreciation deductions spread the cost basis of property over useful life, reducing taxable income while you own the property. On sale, part of the gain attributable to depreciation may be taxed at a depreciation-recapture rate, with the remainder taxed as capital gain.

Example: A property purchased for $5 million with $500,000 in depreciation deductions lowers the cost basis; upon sale, depreciation recapture and capital gains rules apply to the gain.

Features and rules to know

• Withdrawals without penalty generally begin at age 59½ for most retirement accounts.
• Required minimum distributions (RMDs) for many tax-deferred accounts were raised from 70½ to 72 by the SECURE Act and were updated again by SECURE Act 2.0 to 73 for those reaching RMD age in 2023 or later. (Check current rules as they may change.)
• Roth IRAs generally have no RMDs during the original owner’s lifetime.
• Many accounts have contribution limits and income eligibility rules — review plan-specific rules each year.

Traditional IRA vs. Roth IRA — quick comparison

• Traditional IRA
• Contributions may be tax-deductible.
• Earnings grow tax-deferred; withdrawals taxed as ordinary income.
• Subject to RMDs.
• Roth IRA
• Contributions not tax-deductible.
• Earnings and qualified withdrawals are tax-free.
• No RMDs for the owner, but a five-year holding rule applies before earnings can be withdrawn tax-free.

Choosing between Roth and Traditional

• Favor a traditional IRA if you expect your tax rate to be lower in retirement than today (upfront deduction and tax-deferral).
• Favor a Roth IRA if you expect your tax rate to be higher in retirement (pay tax now, enjoy tax-free withdrawals later).
• Consider tax diversification: holding both types can provide flexibility in retirement tax planning.

Common questions

Q: At what age does a Roth IRA “not make sense”?
A: There’s no age when a Roth IRA automatically stops making sense. Consider timing (the five-year rule for earnings withdrawals) and whether paying taxes now is preferable to tax-free withdrawals later.

Q: Should I contribute to a Roth or Traditional IRA first?
A: It depends on your current vs. expected future tax rate. If you expect lower taxes in retirement, prioritize traditional contributions. If you expect higher taxes later, prioritize Roth.

Bottom line

Tax-advantaged accounts and investments are tools to manage when and how much tax you pay. Use tax-deferred accounts to lower taxable income now, and tax-exempt accounts to lock in tax-free growth for the future. The best choice depends on your income, expected future tax rate, time horizon, and financial goals — and tax laws can change, so review rules periodically.