Tax-Advantage

What is Tax-Advantage?

Tax Advantage are the types of investments or saving plans that provides benefits of tax exemption, deferred tax, and other tax benefits. Examples include Government bonds, Annuities, Retirement plans and other investment plans authorized by Tax Department of the country that provide benefit in terms of taxes.

Types of Tax-Advantage Accounts

  1. Pre-Tax Investment Accounts (Deferred Tax): These investments delay your taxes for a later date in the future until the investment provides gains and funds are withdrawn from investments.
  2. After-Tax Investment Accounts: Tax you already paid provides a contribution to this account. Gains/earnings from these accounts will not have any taxes applicable up to a certain limit.

#1 – Pre-Tax Accounts

In the U.S., there are traditional 401(k), 403(b), 457(b) are mostly used employer-sponsored saving plans, most of these plans are funded by an employee, while certain employers provide a matching contribution in these accounts.

#1 – 401(k):
#2 – 403(b):

Especially for employees from non-profit organizations, universities, schools, religious organizations, hospitals, etc.; Tax rules and contributions remain the same as the 401(k) plan.

#3 – 457:

Local and state government employees will have the option to invest in a 457 plan, similar to 401(k) for contribution limit and tax rules, but they do provide some additional tax benefitsTax BenefitsTax benefits refer to the credit that a business receives on its tax liability for complying with a norm proposed by the government. The advantage is either credited back to the company after paying its regular taxation amount or deducted when paying the tax liability in the first place.read more.

  • Double contribution in case employers offering 403(b) when you don’t have more than 3 years for your retirement age;
  • If the employer offers all three mentioned plan, then your investment contribution in this tax-deferred account can be doubled, i.e., $38000 or $50000 (for individual above 50 years).
  • Early withdrawals before the age of 59.5 are subject to taxes, but the penalty is not applicable in this investment account.

Traditional Individual Retirement Arrangement: Under this account, the contribution from an individual’s income is deductible. In case employer of an individual offer employer-sponsored plan and income of an individual cross limit of modified adjusted gross incomeAdjusted Gross IncomeAdjusted Gross Income (AGI) is calculated from the gross income. It represents the net income earned by an individual in a year, including wages, capital gains, and retirement distributions after deducting above-the-line deductions. It determines an individual's taxable income by determining deductions or credits a person is eligible to receive.read more, contribution in this plan may not be allowed for tax deductions.

All above plans are considered with a point of view that when individual retire and withdraw his/her investments, he/she will be into lower-income group compare to the time he/she were in employment, which gives them tax benefits at a future date when you retire.

#2 – After-Tax Retirement Savings Account

An account funded with income after tax is Roth accounts. For people who expect higher tax at retirement compared to the time of employment, select this option.

  1. Roth 401(k), 403(b), 457 Plans: Same as tax-deferred option employer might also provide after-tax investment option. According to these options, individuals will not get any benefit on their contribution to these plans, but they will receive a tax-free distribution on withdrawal after five years or after the age 0f 59.5. Employer contribution will come under traditional plans, and there will be required minimum distribution for an individual over age 70.
  2. Roth Individual Retirement Arrangements: Roth IRA does not provide deduction in tax but, qualified tax-free distributions are available.
Tax-Advantages

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Other Tax Advantage Saving Plans

College/education saving plans

  • 529 plan: Withdrawals are tax-free, but contribution can be decided by individual, whether tax-deferred or after-tax.
  • Coverdell educational saving account: contribution can be made depending on a tax-deferred or after-tax basis, withdrawals available are tax-free but should be used before the child of an individual turn’s age of 30.

Importance

Importance - Tax Advantages

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  1. Promotes Investments: Proper investment with the use of tax-advantaged funds will not just provide benefits in terms of taxes but also promotes investment strategies to individuals.
  2. Multiple Strategies: There are multiple strategies for tax advantage accounts available, depending on the individual’s goals and financial condition. He/she can decide which is more suitable for them.
  3. Future Planning: Individual plans their investment for a future time like retirement, family, child education, healthcare, wealth planning, etc. Such accounts provide an overview and help to decide which strategy every individual should adopt.
  4. Reduce Tax Burden: These investments help in reducing tax burden with various strategies from tax-deferred and after-tax investments. E.g., Government bonds.

Tax-Advantaged vs. Tax-Deferred

Sr.NoTax-AdvantageTax-Deferred
1Tax-advantage is a type of investment, which will benefit an individual in terms of taxation through various investment options.Tax-deferred is a type of investmentType Of InvestmentStocks, bonds, and cash equivalents are the three main forms of investments. Investment, in general, refers to the purchase of anything for future use with the goal of generating a regular cash flow or increasing the value of something over time so that it can be sold for a higher price than it was purchased for, i.e. capital gains. read more, which will delay the taxation on your income for the future at the time of withdrawal.
2There are two types of tax advantages:  1) Tax-deferred and 2) After-tax.Tax-deferred focuses on various investment options, which delays taxation.
3After-tax plans will provide tax-free withdrawal on a plan.Eventually, the individual has to pay taxes on their income on withdrawal after a certain time limit.
4Beneficial for All types of individuals, whether High-income group or lower-income group.Beneficial for High-income group by selecting the tax-deferred plan, the tax might be less on income compare to current earning in case of retirement.

Conclusion

  • Tax planning is an important part of an investment since part of your income you pay to the government as taxes. Whether to choose from tax-deferred investment or after-tax investment option depends completely on individuals’ decision of paying taxes at the time of earning or at the time of withdrawals, although tax-saving today is better, benefits of receiving tax-free withdrawals in future at cost after-tax investment is very high because of investment size.
  • Individuals make a decision based on future financial goals, family requirements, health expenses, educational expenses for children, and wealth creation over a period. Tax-advantages plans provide benefits to all categories of individuals from various income groups. Utilizing both types of tax-advantaged strategies will provide flexibility and benefits.

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