If you’ve had any exposure to retirement or college savings plans, you’ve probably heard the term “tax-advantaged.” It simply means that these types of accounts offer tax benefits that are supposed to incentivize individuals to save. In return, there are typically restrictions on the funds in order to make sure they are used for a specific purpose and not just for general savings. So, just how can these tax-advantaged accounts be more beneficial than a regular savings account?
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They could offer you a bigger paycheck now. Often when we’re considering whether or not to increase our retirement savings by a couple of percentage points, we hesitate because we’re not sure if we can handle seeing a reduction in our paycheck. However, if you’re investing in a Traditional 401(k), your paycheck is not going to be reduced by the full amount of your contributions because they are deducted pre-tax. So, depending on your tax bracket and what state you live in, a $10,000 investment may really only reduce your paycheck by around $7,000.
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Or they could offer you a bigger paycheck later. You’ve probably heard a lot about Roth IRAs and Roth 401(k)s. These are vehicles that allow you to pay taxes on income now, invest it and be able to draw tax-free income in retirement. That means that if you have a $1 million Roth IRA balance 30 years down the line, you’ll have access to the entire balance without having to account for Uncle Sam taking a big chunk out when you need to withdraw your money for income.
Capital gains savings. Tax-advantaged accounts also allow your money to grow tax-free. This can have huge implications when you are talking about holding stocks for a long period of time or ones that have increased dramatically in value. For example, if you had purchased 100 shares of Apple stock in 2009 at around $100 per share and wanted to sell it now at around $520, you would have a gain of more than $40,000. In a taxable account, because you held the investment for more than a year, it would be considered a long-term capital gain and be taxed at up to 20 percent, depending on your tax bracket. However, if you had happened to hold that investment in your child’s 529 plan or an IRA, you would not be taxed on the growth at all.
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As mentioned, be aware that there are limitations to funds invested in tax-advantaged accounts. You can’t access funds in your retirement accounts before you are 59 and a half without incurring a 10 percent penalty and you’ll incur a similar penalty in a 529 account if your child doesn’t end up going to college. However, overall, you could benefit greatly from using these types of accounts as part of your savings plan.
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