Pros & Cons of Tax-Advantaged Accounts

Nothing beats the satisfaction of getting your first salaried job and working hard to earn your income. However, for many of us, when it comes time to collect our first paycheck, we are met with shock and disappointment when a huge chunk of about 10% to 37% of what we thought we’d be bringing home has been automatically deducted for state, federal, social security/medicare, and local taxes.

So, how can you keep Uncle Sam from taking so much every time pay day rolls around? Putting as much as you can into another money-making vehicle is a great way to start. Keeping more of what’s yours so it can continue to grow has always been a well-kept secret of the very wealthy, but it’s also something that everyone can do. So, if the country’s richest can build wealth by saving on taxes, what’s stopping you from throwing your hat in the ring?

This is where a tax-advantaged plan can come in handy. Saving for retirement is an ideal long-term strategy, and it is never too early to get started. Prices are constantly rising, and the only way taxes are going to go down after retirement would be if you reduced your current standard of living, so planning far enough ahead will put you in a better position for your future.

So, how can you create additional income, while saving more of what you make?

Passive Income

As touched upon in my previous article, “Before You Make Your First Investment, STOP and Consider This First,” people often invest in what they know. From traditional stocks and bonds, to interest made off of music licensing and notes, you can earn income beyond your salary through avenues that employ your hobbies, interests, and areas of expertise.

Before I began investing through my IRAs, I dealt in real estate and earned passive income from tenants in my rental properties. But even with this avenue of income, I wasn’t fully maximizing my growth because I was still losing out to state, local, and federal taxations. However, when I put as much as I could into IRAs and 401(k)s and began facilitating my real estate investments through them, I was able to have my money work harder for me.

Depending on the account, different types of tax advantages provided by IRAs can help you hold on to your earnings. So what account types are right for you? Better yet, what specific benefits can you gain from each?

Let’s look at the pros and cons.

Tax-Deferred

Similarly to a 401(k), money is taken out of your paycheck before the government can get its cut with a tax-deferred account, thus reducing what the government is able to tax. You can invest this money for years, and when you reach the age of eligibility for withdrawals, then you’ll pay your taxes at the going rate on the back end.

Pros

1. Tax deferral allows you to pay your taxes at a future date. If your taxes are withheld through wages, this results in a tax refund.

2. You have the ability to move into a lower tax bracket if you lower your taxable income enough. For example, a $90,000 salary taxed at 24% in 2019 can be reduced to a gross income of $84,000 taxed at 22% if you put $6,000 into a 401(k). That’s 2% (or in this case $1,680) less that you pay to the federal government.

3. The money you save from lowering your tax bracket can compound annually to grow your savings. In the example above, if the $1,680 you are not paying compounds at 3% annually, it would grow to $84,005 over 30 years.

4. Even if you choose to spend the money you didn’t pay in taxes, that $6,000 you originally put into your 401(k) each year will continue to grow in this account.

Cons

1. You are subject to Required Minimum Distributions when you reach the eligible age, so you may lose the opportunity to keep that money working for you.

2. With this plan, you’re being taxed on the back end. Upon distribution, the amount you contributed and the monies it earned/accrued is taxed.

3. There is no telling what the tax rate will be or what tax bracket you will be in at by the time you are eligible to take distributions.

Tax-Exempt

These accounts provide advantages to those who can specifically benefit from what they have to offer. If you are saving up for future medical expenses, or have college on your children’s radar, then a tax-exempt plan may be right up your alley.

I personally am a proponent of these tax-exempt accounts, especially the HSA. The funds I’ve been contributing to my HSA over several years came in handy when I had to pay for several medical expenses, all of which happened within one year. When I brought my medical receipts to my CPA, because all my procedures were considered qualified medical expenses, I was able to use the funds from my HSA tax-free.

Pros

1. Health Savings Accounts, or HSAs, use pre-tax income that can be deducted from your gross income and can be used tax-free for qualified medical expenses.

2. Qualified medical expenses for eyeglasses, dental procedures, and deductibles can be paid with the funds in an HSA.

3. Educational Savings Accounts (ESAs) can be funded with post-tax dollars (meaning there’s no deduction on your taxable income) and can be withdrawn tax-free for qualified educational expenses.You can contribute to an ESA until you age of 18, and funds can be held until age 30 for continuing education.

Cons

1. A high-deductible health plan is required to qualify for an HSA, which means you’ll need an eligible insurance plan, and those can get expensive.

2. If you use HSA funds for any non-medical expenses before the age of 65, you will owe a 20% penalty in addition to any taxes due upon withdrawal.

3. ESAs have the lowest contribution limit of all plans.

Post-Tax

Accounts that fall under this category are Roth IRAs and Roth 401(k)s. These are tax-exempt, but because there aren’t any restrictions on what you can use the money for like there are for HSAs and ESAs, I like to consider them as tax-free. They ensure that you can keep just as much, if not more, than what you make because they allow you to be proactive now so that you can protect your money against future tax increases, financial crises, and more. I always like to refer to these accounts as “paying taxes on the seed rather than the crop.”

Pros

1. You pay taxes on the principal up front, but the interests and returns are never taxed.

2. Your tax bracket is likely to rise throughout your career. With this vehicle, you can avoid that higher tax bracket by paying these taxes on the front end.

3. Contributions can be withdrawn without penalty.

4. Qualified withdrawals of earnings within these accounts include first-time home purchases and higher education.

Cons

1. Your contributions will not lower your tax liability.

2. Taxes need to be paid up front when making contributions.

3. There are income limitations for being able to contribute into a Roth IRA (a backdoor Roth conversion would circumvent those limitations, but this can get tricky).

4. You will not receive a tax refund from the government.

No matter which of these accounts you decide to utilize to build your wealth, the common denominator is time. If you haven’t started yet, the best time to start is now. You can ensure your own financial future is safer and that more of the money you make stays in your own pocket.

Still have questions or not sure which tax-advantaged account is right for you? Comment below!