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If you’re trying to save money on your tax bill, you may want to consider opening and funding a tax-advantaged account, which is any financial, savings, or investment account that has a tax benefit attached to it. It may be tax free, tax deferred, or offer other types of tax benefits, such as tax credits. Here is a guide to the most common types.
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Types of tax-advantaged accounts
There are many types of tax-advantaged accounts that you can use to pay less in taxes. Here are some of the most popular.
Retirement accounts
Retirement accounts let you combine saving money on your tax bill with saving for your future.
401(k)
A 401(k) is an account offered by your employer. As an employee you may choose to make elective salary deferrals into your 401(k). With a traditional 401(k) these deferrals are excluded from your taxable income. However, the withdrawals you make from a 401(k) are taxable in retirement. Your employer may offer certain incentives to invest in the company’s 401(k), such as offering an employer matching contribution.
A Roth 401(k) does not give you a tax break in the current tax year, but qualified withdrawals in retirement are tax free instead.
Traditional IRA
A traditional individual retirement account (IRA) is a tax-deferred account. This means you get a tax break in the year when you make contributions to it. However, you will have to pay taxes on the money when you withdraw funds in retirement.
Roth IRA
Contributions you make to a Roth IRA are made after tax—meaning you don’t get a tax break in the current year. However, the funds grow tax free. Withdrawals you make in retirement are also tax free, as long as you meet the criteria for qualified distributions. Make sure to compare the best Roth IRA accounts to minimize your fees.
Education savings accounts
Saving for higher education costs can also save you money on your taxes if you choose the right tax-advantaged vehicle.
529 plan
A 529 plan, also known as a “qualified tuition program (QTP),” allows you to prepay higher education costs at a qualified educational institution or contribute funds to an account to pay higher education expenses.
Coverdell education savings account
A Coverdell education savings account (ESA) is a trust or custodial account set up to pay for qualified education expenses for a designated beneficiary.
Health savings account (HSA)
A health savings account (HSA) is funded with tax-free money. Your withdrawals are also tax free as long as you use the money for qualified medical expenses, such as insurance copayments, deductibles, prescription drugs, etc. You can’t use the funds to pay premiums. To qualify for one you need a high-deductible insurance plan.
Flexible spending account (FSA)
A flexible spending account (FSA) is also funded with tax-free money and doesn’t require any special insurance program. If you use the money for qualified medical expenses, the withdrawals are tax free.
ABLE account
The ABLE account was created by the Achieving a Better Life Experience Act of 2104. It is a tax-advantaged savings account for eligible individuals with disabilities. Withdrawals are tax free if they are used for the designated beneficiary’s qualified disability expenses.
Benefits of tax-advantaged accounts
Tax-advantaged accounts can save you considerable money over your lifetime. Whether you get a tax break in the current year or in the future, tax-advantaged accounts are beneficial. Based on your life circumstances, financial goals, and retirement plans, you should aim to maximize your use of tax-advantaged accounts to minimize your tax bill.
Considerations and limitations
There are specific tax rules for each type of tax-advantaged account. Here’s what you need to know about your eligibility, contribution limits, withdrawal requirements, and possible withdrawal penalties if the funds aren’t used in the proper time frame or for the approved type of expenses.
Retirement accounts
401(k)
There are two annual limits on contributions to your 401(k). The first is a limit on elective salary deferrals, which are pretax contributions you choose to make directly into your 401(k) in lieu of a salary payment. You can make up to $23,000 in elective salary deferrals to your 401(k) in 2024.
The second limit is on the total contributions to your account. This includes your elective deferrals plus all other contributions, such as employer matching or nonelective contributions. In 2024 the total contributions to your 401(k) cannot exceed 100% of your compensation for the year or $69,000, whichever is less.
If you’re age 50 or over, you can make annual catch-up contributions of $7,500. For 2024, this increases your elective salary deferral limit to $30,500 and total contribution limit to $76,500.
If you take money out of your 401(k) prior to the age of 59½, it is considered an early distribution and will be subject to a 10% early withdrawal penalty. There are a few exceptions to the early withdrawal penalty in limited circumstances, such as for hardships, adoption expenses, and first-time homebuyers. You can also withdraw funds penalty free from your 401(k) if you leave your job after the age of 55 (age 50, for public safety employees).
Because your 401(k) funds are taxed when you withdraw money in retirement, you will have to take required minimum distribution (RMDs) starting at age 72 (or 73 if you reach age 72 after Dec. 31, 2022). If you are still employed at age 72 or 73, you may delay RMDs from the 401(k) at your current employer until the year you retire. (You will still owe RMDs on any 401(k)s from past employers if you still have money in those plans.)
Traditional IRA
The annual contribution limit to a traditional IRA in 2024 is $7,000. If you are age 50 or over, you can also make an additional $1,000 catch-up contribution, bringing your total to $8,000. Contributions to your traditional IRA are deductible if they meet certain conditions.
If you or a spouse were covered by an employer-sponsored retirement plan, such as a 401(k), your deductible limit may be reduced or phased out entirely. Here are the phase-out income ranges for 2024.
| Filing Status | Phase-out range if taxpayer is covered by a workplace retirement account | Phase-out range if taxpayer is not covered by a workplace retirement account, but taxpayer’s spouse is |
|---|---|---|
Single or head of household | $77,000 to $87,000 | N/A |
Married filing jointly | $123,000 to $143,000 | $230,000 to $240,000 |
Married filing separately | $0 to $10,000 | $0 to $10,000 |
If you withdraw funds from your traditional IRA prior to age 59½, you will have a 10% early withdrawal penalty unless an exception applies. As with a non-Roth 401(k), because your traditional IRA funds are taxed when you withdraw money in retirement, you will have to take RMDs starting at age 72 (or 73 if you reach age 72 after Dec. 31, 2022).
Roth IRA
As with a traditional IRA, the annual contribution limit to a Roth IRA is $7,000 in 2024. If you are over the age of 50, you can also make an additional $1,000 catch-up contribution, bringing your total to $8,000.
Your Roth IRA contribution limit may be reduced or phased out entirely based on your income. Here are the phase-out income ranges for 2024:
| Filing Status | Phase-out range |
|---|---|
Single or head of household | $146,000 to $161,000 |
Married Filing Jointly | $230,000 to $240,000 |
Married Filing Separately | $0 to $10,000 |
There are no RMDs for a Roth IRA during the account owner’s lifetime. (Note that if you earn too much to contribute to a Roth IRA, there is a backdoor Roth strategy that can enable you to open one. It can have significant tax implications, however.)
Because you pay taxes prior to contributing to a Roth IRA, you can withdraw your contributions tax free at any time for any reason. However, you cannot withdraw earnings on those contributions free of taxes and penalties unless they meet the rules for qualified distributions.
A qualified distribution is made after the account has been open for five years and you have reached the age of 59½. There are a few exceptions to the age rule, such as if you have become totally disabled, take up to $10,000 out for a first-time home purchase, or your account is paid out to a beneficiary after your death.
Education savings accounts
529 plan
Contributions to a 529 plan are not deductible from federal income taxes, but the funds grow tax free. Withdrawals from the account that are used to pay for qualified higher education expenses are also tax free. Amounts not used for qualified higher education expenses are taxed on the earnings.
The maximum contribution limit per beneficiary is set by your state. It ranges from $235,000 in Georgia and Mississippi to $553,000 in New Hampshire. There is no annual limit, but contributions are typically kept under the year’s annual gift tax exclusion, which in 2024 is $18,000 per donor per beneficiary.
Funds not spent on qualified education expenses are subject to a penalty. Permitted expense previously included only “college, university, vocational school, or other postsecondary educational institution” expenses, but now encompass tuition expenses for K-12 education at a public, private or religious school. Certain rules and limits apply.
You can use up to $10,000 out of a 529 plan, per individual per lifetime, to repay student loans for the designated beneficiary or their sibling(s).
Coverdell education savings plan
Like a 529 plan, a Coverdell education savings plan can be used for qualified primary or secondary expenses in addition to higher education costs. Contributions are not tax deductible, but the account grows tax free. Withdrawals from the account that are used to pay for qualified higher education expenses are also tax free. Amounts not used for qualified higher education expenses are taxed on the earnings.
There is no limit to the number of accounts any one beneficiary can have, but the maximum contribution to all accounts for one beneficiary is $2,000 annually. Any funds left in the account by the beneficiary’s 30th birthday must be distributed within 30 days unless the beneficiary has special needs. If the beneficiary dies before reaching age 30, funds must be distributed within 30 days of their death.
Health savings account (HSA)
You can only contribute to an HSA if you have a high-deductible health plan (HDHP), but you can use the funds at any time. In 2024 your annual contribution limit is $4,150 if you are an individual with self-only HDHP coverage. If you have a plan with family coverage, it is $8,300. Payments for qualified healthcare expenses are tax free. Expenses for which you have been reimbursed through other means, such as insurance, do not qualify.
Flexible spending account (FSA)
Unlike an HSA, money in an FSA should be spent by the end of the tax year. However, your employer may offer one of two options for money you have left over at the end of the year. These allow you:
- Up to 2.5 months in the following year to spend leftover money.
- Up to $640 to spend in the following year.
You do not have to participate in an HDHP to qualify for an FSA. You can contribute up to $3,200 in payroll deductions for your FSA in 2024. If your plan allows, your employer can also contribute to your FSA. If your spouse has an FSA through their employer, they may also contribute up to $3,200, for a total household limit of $6,400. AS with an HSA, expenses for which you have been reimbursed through other means, such as insurance, do not qualify.
ABLE accounts
To qualify for an ABLE account, the designated beneficiary must meet one of these four criteria:
- Receive Supplemental Security Income (SSI) based on blindness or disability that began prior to age 26.
- Be in SSI suspense based on excess income or resources but otherwise eligible due to the above rule.
- Receive disability insurance benefits (DIB), childhood disability benefits (CDB), or widow’s with disabilities or widower’s benefits (DWB) based on blindness or disability that began prior to age 26.
- Be the subject of a disability certification.
Typically, the maximum annual contribution is the annual gift tax exemption, which in 2024 is $18,000 per donor per beneficiary. However, the limit is increased if the designated beneficiary is working. In this case the limit is the lesser of:
- The beneficiary’s annual compensation.
- Poverty level for a one-person household in their state for the prior calendar year.
Qualified disability expenses (QDEs) are made for the designated beneficiary related to:
- Education.
- Housing.
- Transportation.
- Employment training and support.
- Assistive technology and related services.
- Health.
- Prevention and wellness.
- Financial management and administrative services.
- Legal fees.
- Expenses for ABLE account oversight and monitoring.
- Funeral and burial.
- Basic living expenses.
How to invest tax efficiently
Here are some steps you can take to efficiently invest your money with regard to taxes.
Open tax-advantaged accounts
Start by contributing to as many tax-advantaged accounts as possible. If you plan to spend a certain amount of money on healthcare costs, you should have either an HSA or FSA.
Retirement planning can also save you money if you invest in tax-advantaged accounts. If you have a child who plans to attend college, they can save money on their taxes in the future if you invest in a 529 plan or Coverdell education savings plan.
Diversify your accounts
Be sure to diversify your account types. If you have both tax-deferred and tax-free accounts, you can save money immediately and in the future.
Match investments with correct account type
The types of investments within your accounts matter. For example, if you have investments that are regularly generating significant income, it’s better to house them in a tax-deferred account.
TIME Stamp: Take advantage of tax-advantaged accounts
If you’re ready to take the first step and open a tax-advantaged retirement, education, or health savings account, you have options. Here are some of our favorites.
- Robinhood for Roth and traditional IRAs with the possibility of a matching contribution.
- Empower for an HSA integrated into your retirement planning.
- M1 Finance to automate and manage your own portfolio in an easy-to-use app.
Empower Financial Advisor
Empower Financial Advisor
Frequently asked questions (FAQs)
What is a traditional IRA vs. a Roth IRA?
A traditional IRA gives you a tax break in the current year. It’s a tax-deferred account because you will pay taxes on the money when you withdraw funds in retirement. You pay taxes on your money prior to funding a Roth IRA, but your investments grow tax free. As long as you meet certain criteria, your withdrawals from a Roth IRA in retirement will also be tax free—and you won’t need to take RMDs from that account in your lifetime (your beneficiaries will). For more information on Roth vs. traditional IRAs, read this article.
Should I contribute to a Roth or traditional IRA first?
If you expect to have a lower income in retirement, a traditional IRA is a good choice. If you expect to have higher income in retirement, a Roth IRA is the better option. The best choice may be to fund both types of accounts and diversify your retirement portfolio.
Is it better to invest in a tax-free account or a tax-deferred account?
A solid retirement strategy is to diversify the types of retirement accounts you own, so your best bet is to fund both types of accounts. Then you will have both a tax-free and tax-deferred source of income in retirement. If you want more information about a Roth IRA vs. 401(k), read this article.
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