What Are Tax-Advantaged Accounts & How Do They Work?

A tax-advantaged account is a savings or investment vehicle that receives special treatment under the tax code to encourage saving for specific goals. These accounts offer benefits by altering when and how taxes are paid on the money within them. The advantages manifest in one of three primary ways, each affecting how your savings can accumulate over time.

The first type of advantage comes from tax-deductible contributions. When you put money into these accounts, you may be able to deduct that amount from your taxable income for the year. This action directly lowers your immediate tax bill, providing an upfront benefit.

Another benefit is tax-deferred growth. In a standard investment account, you owe taxes annually on any dividends, interest, or capital gains your investments generate. With tax-advantaged accounts, those earnings are allowed to grow and compound year after year without being taxed. Taxes are only paid when you withdraw the money.

The third advantage is the possibility of tax-free withdrawals. Certain accounts allow you to take money out without paying any tax on the growth, provided you follow the specific rules for that account. These accounts are often funded with post-tax dollars, meaning you do not receive an upfront deduction for your contributions.

Retirement Savings Accounts

Employer-sponsored plans are a common form of retirement savings, with the 401(k) being the most well-known. These plans allow employees to contribute a portion of their salary directly into an investment account. A feature is the employer match, where the employer contributes a certain amount to the employee’s account based on the employee’s own contributions. The 403(b) plan functions similarly but is offered by public schools and certain non-profit organizations.

Within these employer plans, participants often have a choice between Traditional and Roth contribution types. Traditional contributions are made on a pre-tax basis, which lowers your taxable income for the year you contribute. The investments grow tax-deferred, and withdrawals in retirement are taxed as ordinary income. Roth contributions are made with after-tax dollars, so qualified withdrawals of both contributions and earnings are completely tax-free in retirement.

Individual Retirement Arrangements (IRAs) are accounts that individuals can open on their own, separate from any employer. The two primary types are the Traditional IRA and the Roth IRA, which mirror the tax treatment of their 401(k) counterparts. With a Traditional IRA, contributions may be tax-deductible depending on your income and whether you are covered by a retirement plan at work. Your investments grow tax-deferred, and you pay income tax on withdrawals in retirement.

The Roth IRA operates differently, as contributions are never tax-deductible. They are made with money you have already paid taxes on. The advantage of the Roth IRA is that your investments grow completely tax-free, and qualified withdrawals in retirement are also tax-free. Eligibility to contribute directly to a Roth IRA is subject to income limitations set by the IRS.

For self-employed individuals and small business owners, specific retirement accounts are designed to accommodate their situations. The SEP IRA, or Simplified Employee Pension, allows for contributions for oneself and any eligible employees. Contribution limits are substantial, calculated as a percentage of compensation. The SIMPLE IRA is another option for small businesses and involves mandatory employer contributions, either as a match or a fixed percentage.

Healthcare Savings Accounts

A Health Savings Account (HSA) is a tax-advantaged account for individuals covered by a high-deductible health plan (HDHP). Its structure offers a “triple tax advantage.” Contributions to an HSA are tax-deductible, the funds can be invested and grow tax-free, and withdrawals are also tax-free when used for qualified medical expenses.

One feature of an HSA is its portability. The account is owned by the individual, not the employer, so the funds remain with you even if you change jobs. The balance in an HSA rolls over from year to year, allowing it to grow. This enables the HSA to function as a supplemental retirement savings vehicle, as funds can be withdrawn for any reason after age 65, though they would be subject to income tax if not used for medical expenses.

In contrast, a Flexible Spending Account (FSA) is an employer-sponsored health benefit that allows employees to set aside pre-tax money to pay for out-of-pocket medical expenses. Because contributions are made before taxes, they reduce an individual’s taxable income. The funds can be used throughout the plan year for costs including copayments, deductibles, and prescriptions.

The primary distinction from an HSA is that FSAs are subject to a “use-it-or-lose-it” rule. This means that the funds contributed must be spent by the end of the plan year, or the money is forfeited to the employer. Some employers may offer a grace period or allow a small amount to be carried over. FSAs are tied to employment and are not portable if you leave your job.

Education Savings Accounts

State-sponsored 529 plans are investment accounts designed to encourage saving for future education costs. While contributions are made with after-tax dollars at the federal level, some states offer a state income tax deduction or credit. The primary federal tax benefit is that investments grow tax-deferred, and withdrawals are tax-free when used for qualified education expenses.

These qualified expenses are broad and can include tuition, fees, books, and room and board at most colleges. Recent changes also allow for funds to be used for K-12 private school tuition and certain apprenticeship programs. A recent change allows for tax- and penalty-free rollovers from a 529 plan to a Roth IRA for the beneficiary. This option is for accounts open for at least 15 years and is subject to a lifetime rollover limit of $35,000.

Another option for education savings is the Coverdell Education Savings Account (ESA). Similar to a 529 plan, contributions are made with after-tax dollars, and the investments grow tax-free. Withdrawals are also tax-free when used for qualified education expenses, covering costs from kindergarten through college.

The main differences between a Coverdell ESA and a 529 plan lie in the contribution limits and eligibility. The annual contribution limit for a Coverdell ESA is $2,000 per beneficiary per year. Additionally, the ability for an individual to contribute is subject to income restrictions.

Key Rules and Regulations

The IRS sets annual contribution limits for these accounts. For 2025, the limits for retirement accounts are:

• 401(k): $23,500 for employees. Those age 50 and over can contribute an additional $7,500, while a higher catch-up of $11,250 is available for individuals aged 60 to 63.
• Traditional and Roth IRAs: $7,000, with a $1,000 catch-up for those 50 and older.
• SEP IRA: The lesser of 25% of compensation or $70,000.
• SIMPLE IRA: $16,500 for employees, with a $3,500 catch-up for those 50 and over, which increases to $5,250 for ages 60 to 63.

Contribution limits also apply to health-related accounts for 2025:

• Health Savings Account (HSA): $4,300 for self-only coverage and $8,550 for family coverage, with a $1,000 catch-up for individuals 55 and over.
• Flexible Spending Account (FSA): $3,300, and plans may permit up to $660 to be carried over into the next year.

A “qualified distribution” is a withdrawal that meets the specific purpose of the account, such as reaching retirement age for an IRA or paying for a medical bill with HSA funds. Taking a “non-qualified distribution” before meeting the requirements often results in the withdrawal being subject to ordinary income tax plus an additional penalty tax. This penalty is commonly 10% for retirement accounts, though exceptions can apply.

Moving funds between tax-advantaged accounts without incurring taxes or penalties is possible through a rollover or transfer. A common example is a rollover from a former employer’s 401(k) plan into an IRA. This allows an individual to consolidate retirement assets and maintain their tax-deferred status. The process must be done correctly, either as a direct rollover or as an indirect rollover where the individual has 60 days to redeposit the funds.

For certain retirement accounts, the government mandates that you begin taking withdrawals after you reach a specific age, known as Required Minimum Distributions (RMDs). This rule applies to Traditional IRAs, SEP IRAs, SIMPLE IRAs, and 401(k) plans. Under current law, the age to begin taking RMDs is 73, and this age is scheduled to increase to 75 in 2033. The purpose of RMDs is to ensure that the deferred taxes on these retirement funds are eventually paid. A notable exception is the Roth IRA, which does not have RMD requirements for the original owner.