The government wants to encourage citizens to save money for certain kinds of predictable events—like retirement, education, and medical expenses—so it provides tax breaks for accounts that are dedicated to those purposes. These tax breaks are usually deductions.
There are numerous kinds of tax-advantaged accounts. We'll be discussing a few of the more common ones:
- IRAs are retirement savings accounts that anyone can open,
- 401(k)s and 403(b)s are retirement accounts sponsored by an employer,
- HSAs encourage savings for future medical expenses,
- FSAs provide tax breaks on projected near-term medical expenses, and
- 529 plans are state-specific, but can be helpful when saving for college or other educational expenses.
[TODO: Contribution limits]
Money contributed to a tax-advantaged account can be invested. Investment options depend on the account's provider. Money in an IRA opened at Fidelity, for example, could be invested in a variety of Fidelity's index funds, higher-fee mutual funds, bonds, REITs, or even a money market account (though this last is generally not a good idea in the long term). Your investment options are limited to those offered by your provider.
You can usually put your money in multiple investments within a tax-advantaged account. You might put $5,000 into an IRA, for example, and use that money to buy $4,000 of stock and $1,000 of bonds, choosing those funds from the provider's options.
Withdrawing from a tax-advantaged account
Tax-advantaged accounts are designed to encourage you to save money for a particular use. Using tax-advantaged money for another use (cashing out your 401(k) to buy a car, say) requires paying the previously ignored tax, incurs an additional 10% penalty, and is generally a Bad Idea. If tax advantages are the carrot, penalties are the stick.
Money contributed to a retirement account is only available for withdrawal after you reach a certain age. Money in a 529 plan can only be used for education. FSAs and HSAs must be spent on medical expenses (though HSAs do have an interesting loophole).
Moving money between accounts
Money invested in a tax-advantaged account can often be transferred between providers. This is called rolling over the account.
There are several reasons you might want to roll an account over to a different provider. Maybe the new provider offers better investment choices, or similar investments with lower fees. Maybe you're changing jobs and would like to keep things simple by consolidating your old 401(k) into your new employer's provider (note, though, that this isn't always the optimal thing to do). You might also want to roll your old 401(k) into an IRA.
Some kinds of accounts can only be rolled over under certain conditions. We'll discuss these conditions in the appropriate sections.