Tax-advantaged accounts are exactly what they sound like: accounts that save you taxes on your retirment savings. This is our longest page but stick with us, we promise it's worth your time (and we'll prove it with an example at the bottom of the page).
How it works
There are five steps:
- Each year, you move some money into your tax-advantaged account. The lingo for this is "making a contribution" or "sending some steezy contribs" (we've heard it both ways).
- Use the new money in your tax-advantaged account to buy investments.
- Hold the investments and wait for retirement.
- Once you're retired, sell a small piece of your investments each year.
- Take the cash from your recently sold investments out of your tax-advantaged account so you can spend it. This is called "taking a withdrawal".
Different tax-advantage flavors
There are two types of tax-advantages: "traditional" and "roth". The difference is how they save you money on taxes. With a traditional account your contributionsare tax free, but you need to pay tax eventually when you withdraw money to pay for retirement. A roth account is the opposite: you pay full taxes on contributions, but zero taxes when you withdraw.
Which is better between traditional and roth? It depends. Usually people who start saving early and save aggresively will get better results from roth, but both are much better than a non tax-advantaged account.
Different account structures
There are also two basic structures for tax-advantaged accounts: employer-sponsored or individual. This is where it gets a little confusing: both individual and employer accounts can be either traditional or roth, depending on how they are set up. The difference between account structures (employer vs. individual) is how you make contributions.
An employer-sponsored account (401k or 403b) is set up by your employer. You contribute to a 401k/403b by deducting money directly from your paycheck. One very, very important aspect of 401k/403b accounts: some employers match contributions up to a limit. In other words, if you save money in your 401k/403b your employer will pay you extra straight into your 401k/403b. Employee's who don't contribute enough to get the full match are missing out on free money.
If you don't have access to a 401k/403b, don't worry. Anyone can create an individual retirement account (IRA). First you choose a broker (Vanguard, Fidelity, Charles Schwab, etc) to create the IRA (a quick online setup). For an IRA, you contribute by transferring money from your bank account.
Because tax-advantaged accounts are such a good deal, the government limits your yearly contributions (thanks, Obama). In 2022, the limits were $20,500 for your 401k/403b and $6,000 for your IRA. The best way to supercharge your savings is to have a 401k/403b and an IRA and max out contributions to both.
Who cares
What difference does any of this make? Let's look at an example. Enter your age, annual gross income (how much you make each year before taxes), and how much you spend each year. We'll show you what happens if you save what's left over in three different ways: not using any tax-advantaged accounts, using traditional accounts, and using roth accounts.
Current Age Annual Gross Income (Before Taxes) Annual Spending