What Is a Tax-Advantaged Account?

Quick Answer

A tax-advantaged account is a savings or investment account that can save you money on taxes with either deductible contributions and tax-deferred earnings or tax-exempt earnings and tax-free withdrawals. Examples of tax-advantages accounts are IRAs, 529 college savings plans, health savings accounts (HSAs) and 401(k) plans.

A man sitting on a wheelchair in dining room, researching tax advantaged accounts on his laptop.

A tax-advantaged account is a special-purpose savings or investment account that offers tax benefits when you save toward a specific goal, such as retirement or paying for college. Tax-advantaged accounts allow you to reduce your taxable income now, defer paying taxes on earnings until later or let your money grow tax-free while it's in your account. A tax-advantaged account can help you reach your savings goals faster by reducing your tax burden; it can also help round out your investment portfolio by decreasing the taxes you owe on gains or dividends.

What Is a Tax-Advantaged Account?

A tax-advantaged account offers tax savings that encourage you to reach your savings goals. Some tax-advantaged accounts offer pretax contributions that reduce your taxable income for the year. They may also offer tax-deferred or tax-exempt earnings, so you either postpone paying taxes as your money grows or avoid paying taxes on capital gains or dividends.

Tax savings are meant to be an incentive to save for big goals like retirement, college or caring for a special needs child. But tax benefits also help you save more, by putting more of your money into your account (instead of sending it to the IRS) and keeping it there, again instead of withdrawing it to pay taxes.

Tax-Deferred vs. Tax-Exempt Accounts

Tax-deferred accounts delay your tax liability; tax-exempt accounts earn money tax free. Here are three key terms to understand:

  • Pretax contributions are excluded from your taxable income. They may be deducted from your paycheck before taxes, or you may deduct contributions from your income on your tax return. Either way, pretax contributions reduce your taxable income in the year you contribute.
  • Tax-deferred earnings are untaxed now but taxable later. As an example, dividends, interest and capital gains earned in a traditional individual retirement account (IRA) or 401(k) plan are not taxed until you withdraw your money. At that point, all your distributions are taxable, since contributions were pretax and earnings were tax-deferred up to that point.
  • Tax-exempt earnings are not taxable, now or later. For instance, investments in a Roth IRA may appreciate in value, earn dividends and generate capital gains, but any money earned inside a Roth IRA is tax exempt. And because you fund a Roth IRA with after-tax dollars, your withdrawals are tax-free.

Types of Tax-Advantaged Accounts

The federal government has created several types of tax-advantaged accounts to encourage taxpayers to save money toward certain goals, like retirement or covering unreimbursed medical expenses. Here are six types of tax-advantaged accounts that can help you save money on taxes and grow your savings.

401(k)s and Other Employer-based Retirement Plans

Employer-based retirement plans—such as 401(k), 403(b) and 457 plans—let you contribute to tax-advantaged retirement funds through your work. These plans typically allow automatic payroll deductions and, depending on your employer's policies, may provide matching funds that increase your contributions. A 401(k) can be either a tax-deferred traditional plan or a tax-exempt Roth 401(k).

Individual Retirement Accounts (IRAs)

As long as you have taxable income, you can contribute to a tax-advantaged IRA and save toward retirement. Like 401(k) plans, different types of IRAs provide different tax benefits.

  • Traditional IRAs are tax-deferred. Contributions are deductible and earnings are untaxed until you withdraw your money.
  • Roth IRAs are tax-exempt. Contributions are not deductible, but earnings and withdrawals are tax-free.

529 Educational Plans

Tax-advantaged 529 savings plans allow you to save for college or other qualifying educational expenses with tax-exempt earnings at both the state and federal levels. These plans are administered by states. Some states may offer additional incentives for saving in a 529. Although 529s are often referred to as college savings plans, in some cases you may also use 529 funds for graduate school, apprenticeships or K-12 tuition.

Coverdell Education Savings Accounts

Coverdell education savings accounts are tax-advantaged accounts designed to help save for college. Coverdell accounts allow tax-free withdrawals as long as the funds are used for qualifying education expenses. Contributions are not tax-deductible, and contributing grandparents and parents must meet income requirements. Coverdell accounts are typically trusts or custodial accounts for children under 18 or beneficiaries with special needs.

Health Savings Accounts

Health savings accounts (HSAs) allow both pretax contributions and tax-exempt growth, as long as distributions are used to pay for qualified health care expenses when you withdraw the money. Because these dual tax advantages (tax-deductible contributions and tax-free withdrawals) are unusual, some savers use HSAs to stash money away for retirement. Two important caveats, though: First, you must have a qualifying high-deductible health plan to fund an HSA. Second, your withdrawals are only tax-free if they're used to pay for health-related expenses.

Achieving a Better Life Experience (ABLE) Accounts

Eligible people with disabilities can contribute (or accept contributions) to an ABLE account. ABLE accounts are administered by states, so tax rules may vary depending on where you live. Commonly, ABLE accounts are funded with after-tax dollars; withdrawals are tax-free. In addition to tax savings for qualified expenses, ABLE accounts may allow beneficiaries to accrue assets without losing eligibility for benefits like Supplemental Security Income (SSI) and Medicaid.

How to Invest Tax-Efficiently

Minimizing taxes is a common goal, whether you're investing toward goals like retirement or simply to make money. Tax-efficient investing encompasses many strategies and tactics, including investments in tax-efficient exchange-traded funds (ETFs) and tax-advantaged municipal or Treasury bonds, and holding on to investments for a year or longer to get a more favorable tax rate.

These five ideas can get you started with tax-efficient investing.

1. Add Tax-Advantaged Accounts

Tax-advantaged accounts can help you contribute more (by offering tax deductions), keep more of your earnings invested or avoid paying taxes as your money grows—but only if you open and use them. Because these accounts have targeted uses, like retirement or college savings, it makes sense to choose only accounts that help you meet actual goals. But, where they make sense, tax-advantaged accounts save you money. Even when your portfolio also includes taxable investments, adding tax-advantaged accounts gives you an option that can help reduce your tax bills.

2. Make Tax-Deductible Contributions

Consider the value of contributing to a traditional IRA, 401(k) or other type of account that allows pretax contributions. Although you're only deferring your tax liability, sometimes reducing your tax bill immediately is a priority. Moreover, saving money on taxes this year could translate directly into more money to invest.

3. Consider Maximizing Tax-Exempt Accounts

Although you don't get a tax deduction for contributing to tax-exempt accounts like Roth IRAs or 529 plans, tax-exempt earnings and tax-free distributions can be a big advantage when it's time to take money out. Depending on your retirement tax strategy, you may want to look into converting traditional IRA or 401(k) accounts into Roth accounts. You'll have to pay regular income taxes on the funds you convert, but you won't have to take required minimum distributions or pay taxes on your Roth money going forward.

4. Be Strategic With Earnings and Gains

If you maintain both taxable and tax-advantaged accounts, think strategically when structuring or rebalancing your accounts. You may want to make more profitable trades or generate more income in tax-exempt accounts like Roth IRAs or HSAs. Alternatively, you may want to pay some taxes on growth as you go (in a taxable account) rather than defer all of your taxes (in a traditional IRA, for example) until retirement, when deferred taxes could create a retirement tax bomb.

5. Plan for Taxes in Retirement

Speaking of retirement, you may want to give extra thought to tax planning in your retirement years. Timing—and balancing—income from taxable, tax-deferred and tax-exempt sources can affect how much you'll pay in taxes. Consulting with a retirement financial advisor or tax professional with expertise in retirement tax planning may help you sort through the complexities.

The Bottom Line

Tax-advantaged accounts help you do two things most investors like: save money on taxes and maximize returns. While there are good reasons to have both tax-advantaged and taxable investment accounts (if you have the resources to fund both), IRAs, 401(k)s, 529s, HSAs and other tax-advantaged accounts are often the first choices for savers who are saving toward retirement, education, health care expenses or help for a disabled family member.