What Is Tax-Advantaged?

The term “tax-advantaged” refers to any type of investment, financial account, or savings plan that is either exempt from taxation, tax-deferred, or that offers other types of tax benefits. Examples of tax-advantaged investments are municipal bonds, partnerships, UITs and annuities. Tax-advantaged plans include IRAs and qualified retirement plans such as 401(k)s.

Understanding Tax-Advantaged

Tax-advantaged investments and accounts are used by a wide variety of investors and employees in various financial situations. High-income taxpayers seek tax-free municipal bond income, while employees save for retirement with IRAs and employer-sponsored retirement plans.

 The two common methods that allow people to minimize their tax bills are tax-deferred and tax-exempt status. The key to deciding which, or if a combination of both, makes sense for you comes down to when the tax advantages are realized.

Tax-Deferred Accounts

Tax-deferred accounts allow you to realize immediate tax deductions on the full amount of your contribution, but future withdrawals from the account will be taxed at your ordinary income rate. The most common tax-deferred retirement accounts in the U.S. are traditional IRAs and 401(k) plans. In Canada, the most common is a Registered Retirement Savings Plan (RRSP).

Essentially, as the name of the account implies, taxes on income are "deferred" to a later date.

For example, if your taxable income this year is $50,000 and you contributed $3,000 to a tax-deferred account, you would pay tax on only $47,000. In 30 years, once you retire, if your taxable income is initially $40,000, but you decide to withdraw $4,000 from the account, taxable income would be bumped up to $44,000.

Tax-Exempt Accounts

Tax-exempt accounts, on the other hand, provide future tax benefits because withdrawals at retirement are not subject to taxes. Since contributions into the account are made with after-tax dollars, there is no immediate tax advantage. The primary advantage of this type of structure is that investment returns grow tax-free. Popular tax-exempt accounts in the U.S. are the Roth IRA and Roth 401(k). In Canada, the most common is a tax-free savings account (TFSA).

If you contributed $1,000 into a tax-exempt account today and the funds were invested in a mutual fund, which provided a yearly 3% return, in 30 years the account would be valued at $2,427. By contrast, in a regular taxable investment portfolio where one would pay capital gains taxes on $1,427, if this investment were made through a tax-exempt account, growth would not be not taxed.

With a tax-deferred account, taxes are paid in the future but with a tax-exempt account, taxes are paid right now. However, by shifting the period when you pay taxes and realizing tax-free investment growth, major advantages can be realized.

Key Takeaways

  • Tax-advantaged refers to favorable tax status held by certain qualified investments, accounts, or other financial vehicles.
  • Common examples include municipal bonds, 401(k) or 403(b) accounts, 529 plans, and certain types of partnerships.
  • Tax-deferred status means that pre-tax income is used to fund an investment where taxes will be paid at a later date and at current tax rates at that time.
  • Tax-exempt status uses after-tax money to fund investments where gains or income produced by them are not subject to ordinary income tax.

Tax-Advantaged Investments

Tax-advantaged investments shelter some or all of an investor’s income from taxation, allowing him or her to minimize his or her tax burden. Municipal bond investors, for example, receive interest on their bonds for the duration of the bond’s life. The proceeds from issuing these bonds to investors is used by municipal authorities to fund capital projects in the community. To incentivize more investors to purchase these bonds, the interest income received by investors is not taxed at the federal level. In many cases, if the bondholder resides in the same state where the bonds was issued, his or her interest income will also be exempt from state and local taxes.

Depreciation also yields tax advantages for individuals and businesses that invest in real estate. Depreciation is an income tax deduction that allows a taxpayer to recover the cost basis of certain property. In the U.S, the cost of acquiring a land or building is capitalized over a specified number of useful years by annual depreciation deductions. For example, assume an investor purchases a property for $5 million (the cost basis). After five years, he has depreciation deductions of $500,000 and his new cost basis is $4.5 million. If he sells the property for $5.75 million, his realized gain will be $5.75 million - $4.5 million = $1.25 million. The $500,000 deduction will be taxed at the depreciation recapture rate and the remaining $750,000 will be taxed as a capital gain. Without the tax advantage of the depreciation allowance, the entire gain realized from the sale of the property will be taxed as a capital gain.

Tax-Advantaged Accounts

With regular brokerage accounts, the IRS taxes investors on any capital gains realized from selling profitable investments. However, tax-advantaged accounts allow an individual’s investing activities to be tax-deferred and, in some cases, tax-free. Traditional Individual Retirement Arrangements (IRAs) and 401(k) plans are examples of tax-deferred accounts in which earnings on investments are not taxed every year. Instead, tax is deferred until the individual retires, at which point s/he can start making withdrawals from the account. Withdrawing from these accounts without penalty is allowed once the account holder turns 59½ years old. Once s/he reaches 70½ years, s/he is required to start taking minimum withdrawals from the account.

Roth IRAs and Tax-Free Savings Accounts (TFSAs) offer even more tax savings for investors than tax-deferred accounts, as activities in these accounts are exempt from tax. Withdrawals and earnings in these accounts are tax-free, providing a perfect example of a tax advantage.

Governments establish the tax advantages to encourage private individuals to contribute money when it is considered to be in the public interest. Selecting the proper type of tax-advantaged accounts or investments depends on an investor's financial situation.