February 15, 2021
Meet the Tax-Advantaged Account Types!
Thinking about taxes can stir up a lot of emotions. Likely due to the fact that taxes generally work against you... however, this is not always the case!
Funding the appropriate accounts and planning your investments strategically can drastically increase your tax efficiency thus leading to lower long-term tax bills.
First off, there are three types of accounts: taxable, tax-deferred, and tax-free.
In this context, a “taxable” means that whatever money you put into the account has already been taxed. Then as your investments pay out dividends or interest payments, these get taxed, and if your investments increase in value, you are taxed again when you sell the investment based on the amount of growth. Thus, these accounts do not have any tax advantages, but do not carry any limit as to how much can be contributed to them each year.
The most common tax-deferred accounts are Traditional IRAs and Traditional 401Ks. Tax-deferred plans are typically used for retirement savings. The money goes into the account pre-tax and you will not be taxed until you withdraw your money. This allows for a larger principal contribution, thus more money at work accruing interest. Then, once you reach 59.5, you can begin to withdraw the money without any early withdrawal penalties and will be taxed at your ordinary income rate.
Roth IRAs and Roth 401Ks are the most common tax-free accounts. These accounts are funded with money you have already been taxed on, but when you make a “qualified withdrawal,” you do not pay any taxes. Thus, providing huge benefits to those who anticipate being in a higher tax bracket later in life.
There are several nuisances to each account type and working with a Certified Financial Planner™ can help you to map out the best strategy for you personally to fund each account.