Tax-advantaged accounts offer powerful tools for individuals looking to maximize their savings, especially for retirement, healthcare and education.
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Understanding the differences between the various tax-advantaged accounts can help you make informed financial decisions.
Annuities
Annuities are financial products designed to provide a steady stream of income. They involve tax-deferred growth and are usually an insurance contract, where you make a lump sum payment or a series of payments. In return, the insurance company agrees to make periodic payments to you in the future, which are often used to help you manage retirement income.
They offer great benefits, yet remain one of the least-understood retirement accounts, said Paul Tyler, host of “That Annuity Show.”
“Like Social Security, annuities can provide you with guaranteed checks each month that you will never outlive,” Tyler said. “You shouldn’t consider buying one until at least your late fifties or early sixties. However, at that point in time, it can create a great supplemental stream of income that you can count on forever.”
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IRA
A traditional individual retirement account (IRA) allows you to contribute pre-tax money up to a set limit — $7,000 in 2024, or $8,000 for those 50 and older. While you will have to pay income taxes on withdrawals, your contributions decrease your taxable income in the years you make them.
Note that there are penalties for withdrawing funds from an IRA before you are age 59 1/2.
Roth IRA
Roth IRAs are contributions made with after-tax income, and withdrawals are tax-free in retirement. They provide tax-free growth, and qualified withdrawals provide flexibility for tax planning in retirement.
“The tax-free income that a Roth IRA provides can be a big boost to a retiree’s financial plan,” said Matt Mancini, a wealth planning team leader at Wilmington Trust. “Many people will look at their tax rates now and in the future to determine what makes sense for them.”
Mancini explained, “When you make a Roth contribution, there is no current income tax benefit for that contribution; it’s an after-tax amount. However, the benefit in the Roth is on the back end, where qualified distributions are generally tax free. This is true for the beneficiaries of [the account], as well, which can be a nice benefit for your heirs.”
Health Savings Account (HSA)
Health Savings Accounts (HSAs) provide three tax benefits: They are tax-deductible, growth is tax-free, and qualified withdrawals for medical expenses are tax-free.
“Another benefit to the Health Savings Account is you have penalty-free access to the account once you turn 65,” Mancini said. “This means that you can use the account for any purpose, not just medical expenses, and not pay a penalty on those distributions. … In that respect, it kind of turns [the HSA] into an IRA at age 65 with a tax-free distribution option.”
Before you turn 65, any withdrawals from the account that are not used for medical expenses would be subject to tax.
529 Savings Plan
In a 529 Savings Plan, your earnings grow tax-free, and your withdrawals are tax-free if you use the money for qualified education expenses. These include tuition and fees up to $10,000 annually, room and board, books and supplies, special needs equipment, apprenticeship programs, student loan repayments, and computers, software and internet access.
Some states offer tax deductions or credits for contributing to your 529 Plan. It can also be transferred between family members without penalties.
401(k)
Employer-sponsored 401(k) plans are set up through your employer and often allow for automatic contributions through payroll. Like an IRA, contributions to a traditional 401(k) are made with pre-tax dollars and reduce your amount of taxable income in a year. These accounts are meant for retirement savings, so they are also subject to early withdrawal penalties.
Solo 401(k)
Many self-employed people shy away from retirement plans, because they don’t understand their options or their revenues fluctuate every year, said Jarrod Randall, CPA and partner consultant at Xero, a small business cloud accounting platform.
However, the Solo 401(k) is a retirement savings plan for self-employed individuals or small business owners without employees. As an employee, you can contribute up to $23,000 in 2024 or $30,500 if you are 50 or older.
“The shining benefit of the Solo 401(k) is that you and potentially a spouse — if they earn income from the business — can contribute via salary deferrals plus up to 25% of your net earnings from self-employment,” Randall said. “You can also choose a Roth Solo 401(k) to get the tax treatment of a Roth IRA.”
SIMPLE IRA
The Savings Incentive Match Plan for Employees (SIMPLE) IRA offers a simplified way for employers to provide retirement benefits to their employees without the administrative complexity of larger plans like a 401(k).
“For business owners with employees, the SIMPLE IRA is a great plan, allowing for contributing net self-employment earnings as well as either a 2% fixed contribution or a 3% matching contribution,” Randall said. “All of these options generally offer higher contribution limits as a business owner, as well as greater flexibility.”
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This article originally appeared on GOBankingRates.com: Understanding Tax-Advantaged Accounts and Their Benefits
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