Tax-Advantaged Accounts for Stocks

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Tax-Advantaged Accounts for Stocks

One easy way to become a more tax-efficient stock investor is to utilize tax-advantaged accounts such as 401(k)s and individual retirement accounts (IRAs). These special accounts allow you to enjoy either tax-deferred or tax-free growth of your investments.

Tax deferral can lead to significant savings over time. Let’s assume two investors each start with $10,000 and earn a 10% annual return for 30 years. One has 100% of her gains tax-deferred, while the other realizes the full amount of his capital gains each year and pays a 20% tax on those gains. Under this scenario, the tax-deferred investor ends up with almost $75,000 more at the end than the investor with the taxable gains.

Clearly, it is worthwhile to learn about the types of tax-advantaged accounts available. Below are some of the most popular:

401(k)s

401(k) plans, so named after a section of the Internal Revenue Code, are set up by employers as a retirement-savings vehicle. The primary advantage of a 401(k) is tax deferral. First, employees can contribute a percentage of their income from each paycheck to their own 401(k) accounts on a pretax basis. This means the amount you contribute to your 401(k) is exempt from current federal income tax. For example, if you are in the 24% income tax bracket, a $100 contribution will reduce your current tax burden by $24. Second, dividends and capital gains earned inside a 401(k) are not subject to current taxation. In short, 401(k) plans allow you to defer taxation on dividends, capital gains, and a portion of your wages until you begin withdrawing from the plan, presumably during retirement, when you may be in a lower tax bracket. (All withdrawals are taxed at ordinary income rates.)

The amount you can contribute to your 401(k) plan is limited to $23,000 in 2024. You also must begin mandatory withdrawals from your 401(k) when you reach age 73. Withdrawals made before you turn 59½ are taxed as ordinary income, and you may be subject to an additional 10% penalty.

Traditional IRAs

Individual retirement accounts are another vehicle for tax deferral. When you contribute to a traditional IRA, the IRS allows you to take an income tax deduction up to the amount of the contribution, subject to income limitations. In addition, dividends and capital gains earned inside a traditional IRA are not subject to tax until withdrawal.

However, there are some important limitations to remember. First, you must have earned income to contribute to a traditional IRA. Second, the annual contribution limit is $7,000 in 2024. If you are age 50 or older, you can make additional "catch-up" contributions of $1,000. Finally, like 401(k) plans, you must begin mandatory withdrawals when you reach age 73. Withdrawals made before you turn 59½ are taxed and may be subject to an additional 10% penalty.

Roth IRAs

These are typically the best retirement account option for many taxpayers. As with traditional IRAs, interest income, dividends, and capital gains accumulate tax-free. However, the main feature of Roth IRAs is that they are funded with aftertax dollars (contributions are not tax deductible). The upside of this is that qualified distributions from a Roth IRA are exempt from federal taxation.

The Roth IRA has the same annual contribution limits and "catch-up" provisions as a traditional IRA, but you must meet certain income requirements to contribute to a Roth IRA. Generally, single filers with income up to $146,000 and joint filers with income up to $230,000 are eligible to make the full annual contribution to a Roth IRA. Contributions to a Roth IRA can be withdrawn at any time without paying taxes or penalties, but withdrawal of earnings may be subject to income taxation and a 10% early withdrawal penalty if made before you turn 59½.

In addition, the distribution must also be made after a five-tax-year period from the time a conversion or contribution is first made into any Roth IRA. So, if you opened your first Roth IRA and make your first contribution on April 15, 2024, for the 2023 tax year, your five-year period started on Jan. 1, 2023. Assuming you meet the other requirements, distributions made in this case after Dec. 31, 2028, from any Roth IRA will receive tax-free treatment.