"Like mothers, taxes are often misunderstood, but seldom forgotten.'' — Lord Bramwell, 19th Century English jurist https://www.irs.gov/uac/tax-quotes
This guide is intended for folks who have built up an emergency fund and feel ready to start saving more. The focus is on tax strategies, but we also cover general guidance about how to compare and weigh financial decisions. This is not a guide for what to invest in.
If this all sounds like gibberish, check out the Reddit /r/personalfinance commontopics wiki.
A tax advantaged account is any account that lets you pay less taxes, either today, or in the future. It can be an account you have through your employer, like a 401k, or an account that you start yourself, like an Individual Retirement Account (IRA). Many of the accounts are aimed at helping people retire, but there are also tax advantaged accounts for other goals like education (e.g. 529 college savings account), dependent care (Flexible Spending Accounts FSA), and healthcare (Health Savings Accounts HSA).
- IRS Publication 4484: Choose your retirement plan
- IRS 529 Plans: Questions and Answers
- IRS Publication 969: Health Savings Accounts and Other Tax-Favored Health Plans
Each type of account has it's own benefits, but there are some general concepts that help in understanding how these accounts work. Not every account will have these benefits, and different accounts types may phase out benefits based on income limits. Each benefits is good on it's own, but combining them is where the big savings start happening.
Instead of paying taxes on income you earned this year, tax deferral lets you pay taxes later. You still have to pay taxes eventually, but you get to choose what to do with this extra money until it's due. It could come as part of a tax rebate check, or it could mean more take-home money per paycheck because you owe less taxes.
On top of having money sooner, you could pay less tax overall if you're in a lower tax bracket when you decide to pay the tax. Tax rates depend on how much money you make. The more you make, the higher the tax bracket percentage. Your highest tax bracket is called your marginal tax rate. For example, if you contribute $100 to a tax deferred account when you're at a 25% marginal tax rate, and you take the money out later when're you're at a 10% marginal tax rate, you only pay $10 of tax instead of $25 when you were at the higher tax bracket. However, the converse is also true. If you're at a 15% marginal rate today, and you take the money out when you're at a 25% marginal rate, you'd pay the higher tax. If you live in a state with income tax, that's another marginal tax rate to consider as well.
The IRS usually taxes you when you make money, but there are a few rare exceptions. Tax free growth means that any money you make from your initial contributions aren't taxed in that year. Depending on what account the growth occurs, taxes on growth are treated differently.
To illustrate taxable growth, imagine your bank paid you $1,000 in interest in your savings account (ya, I wish too), you'd get a tax bill at the end of the year with that interest as if you had made it from working. If you're in the 25% tax bracket, that's $250 to Uncle Sam. However, if you made that same $1,000 in an account with tax-free growth, you wouldn't owe taxes on that $1,000.
Not only did you save $250 in taxes, but thanks to compounding interest, you get growth on top of growth, and it's also tax-free. The normal savings account also experiences compounding interest, but because growth is taxed every year, we say it experiences tax drag. Think of it like a parachute that's slowing down your savings because some of your growth is going to the IRS each year.
"Distribution" means taking money out of an account. Any money that you've already paid taxes on won't get taxed again. However, any growth you've made is fair game for taxes. In some cases, the IRS gives you a free pass to take growth out without taxes.
Both traditional and Roth contributions grow tax free. However, Roth distributions can be tax-free, while traditional distributions are taxed. Both types of contributions are useful, but which one you choose depends on your situation.
- Reddit: Roth or Traditional?
- Can we talk about the misconceptions people have when choosing a Roth over a Traditional IRA?
Estate planning
There are rules for what happens to accounts you hold when you die. If you're married, they typically transfer to your spouse, but if they get passed onto your heirs or to a charity, there are different treatments for taxes.
With all these great tax savings, when wouldn't you want to take advantage of these tax advantaged accounts?
Liquidity
Tax advantaged accounts don't make sense for money you need right away or in the near future. Accounts can have penalties for early withdrawal, and rules for what the funds are used for (e.g. healthcare, education, retirement). For example, it doesn't make sense to hold your emergency fund in tax advantaged accounts because it would take longer to pull that money out than a savings or checkings account, and you may have to pay a penalty on top of any taxes owed. There are exceptions to early distributions, but funds you know you'll need in the near future still belong in savings account.
Use it or lose it
Flexible Spending Accounts (FSAs) are tax deferred, but most of it's funds must be used before the end of the year. The Affordable Care Act allows up to $500 of funds to be rolled over into the following year for healthcare related FSAs. This downside is specific to FSA's, but these accounts are still useful if you know ahead of time that you'll definitely spend all of the funds before the end of the year. Dependent care and commuter transit passes are examples of expenses that you may know you need ahead of time.
Investment options
Some accounts have limited investment options, or investment options with high fees that eat into your money growth. Fortunately, there are often opportunities to rollover an account into a different one that has better investment options. Accounts of the same type can usually be rolled into each other, and the IRS defines what accounts can be rolled into what.
Tax changes
Tax deferral is a double edged sword. You win if the tax rate on distribution is lower than your tax rate when you contributed. It's impossible to predict what tax brackets will look like in the future, so there's some risk that you could end up in a higher bracket than you expected. Many years of tax-free growth can help offset some of this risk, but that depends on when you start contributing.
Required minimum distributions (RMD)
Theoretically, if you deferred taxes forever, you'd never have a tax bill right? There's a rule against that. Tax advantaged accounts may force distributions over time. For example, traditional IRAs require you to start taking distributions the year you turn 70.5 years old. You can take money out sooner than that, but once you hit RMD, you have to take at least the required amount out and pay taxes on it. On the other hand, Roth IRAs do not have RMD.
Paying less taxes be a huge boost in savings, but it's important to weigh these tax savings with downsides to figure out what makes sense for you. One way or another, if you make money, the IRS will get a cut... eventually. But the amount of tax you pay can change drastically based on where you put your money, when you pay taxes, and how much time your money grows.