How to Use Tax-Advantaged Accounts to Build Wealth

June 3, 2023

Let's be honest, talking about money can be a little uncomfortable. But when it comes to building long-term wealth, understanding how taxes play a role is absolutely crucial. Simply saving money isn't enough – you need to consider the impact of taxes on your returns. Fortunately, there are powerful tools available that allow you to grow your investments while significantly reducing your tax bill. These are known as tax-advantaged accounts, and mastering their use can be a game-changer for your financial future.

What Are Tax-Advantaged Accounts?

These accounts offer unique benefits that allow your investments to grow without being immediately taxed. Instead, you pay taxes later, typically when you withdraw the money in retirement. This delay of taxation is the key to their effectiveness. Let’s take a look at some of the most popular types:

401(k) Plans: Offered through employers, 401(k)s allow pre-tax contributions, meaning the money you put in reduces your taxable income now. Many employers even offer matching contributions, essentially “free money” to boost your savings.
Traditional IRAs: Similar to 401(k)s, contributions to a Traditional IRA are often tax-deductible, and your investments grow tax-deferred.
Roth IRAs: With a Roth IRA, you contribute after taxes have been paid, but qualified withdrawals in retirement are completely tax-free. This can be a huge advantage if you anticipate being in a higher tax bracket later in life.
529 Plans: Primarily for education savings, 529 plans allow for tax-free growth and withdrawals for qualified education expenses. They’re a fantastic way to save for your children’s college education while benefiting from tax advantages.

How They Work – A Quick Example

Let’s say you contribute $6,000 to a Traditional IRA and your investments grow to$ 8,000 over 30 years, earning an average annual return of 7%. If you withdrew the full $8,000 in retirement, you'd owe taxes on the entire$ 8,000 plus the earnings, which could be a substantial amount. However, because the money grew tax-deferred, you’d only pay taxes on the $8,000 withdrawal itself.

Strategic Considerations

Start Early: The sooner you start, the more time your investments have to grow, and the greater the tax advantages will be.
Take Advantage of Employer Matching: Don't leave "free money" on the table! Contribute enough to your 401(k) to get the full employer match.
Consider Your Tax Bracket: If you believe you’ll be in a higher tax bracket in retirement, a Roth IRA might be a better choice than a Traditional IRA.
Diversify Within Your Accounts: Don't put all your eggs in one basket. Create a well-diversified portfolio within each of your tax-advantaged accounts.

Disclaimer: This information is for general knowledge and informational purposes only, and does not constitute investment advice. It is essential to consult with a qualified financial advisor before making any investment decisions.*