Tax advantage

Last updated December 11, 2024

Tax advantage refers to the economic bonus which applies to certain accounts or investments that are, by statute, tax-reduced, tax-deferred, or tax-free. Examples of tax-advantaged accounts and investments include retirement plans, education savings accounts, medical savings accounts, and government bonds. Governments establish tax advantages to encourage private individuals to contribute money when it is considered to be in the public interest.

Benefits

Tax advantages provide an incentive to engage in certain investments and accounts, functioning like a government subsidy. For example, individual retirement accounts are tax-advantaged since they are tax-deferred. By encouraging investment in these accounts, there is a reduced need for the government to support citizens later in life by spending money on welfare or other government expenses. Capital gains tax rate benefits may also spur investment.

Types of tax-advantaged accounts and investments

Retirement plans

The most well-known example is retirement plans, which often offer tax advantages to incentivize saving for retirement.

In countries in which the average age of the population is increasing, tax advantages may put pressure on pension schemes. For example, where benefits are funded on a pay-as-you-go basis, the benefits paid to those receiving a pension come directly from the contributions of those of working age. If the proportion of pensioners to working-age people rises, the contributions needed from working people will also rise proportionately. In the United States, the rapid onset of Baby Boomer retirement is currently causing such a problem.

However, there are international limitations regarding tax advantages realized through pensions plans. If a person with dual citizen in the United States and in the United Kingdom, they may have tax liabilities to both. If this person is living in the United Kingdom, their pension could have tax advantages in the UK, for example, but not in the US. Even though a UK pension may be exempt from UK tax, it doesn't necessarily mean that it is exempt from US taxes. In short, a US Tax payer with dual citizenship may have to pay taxes on the gains from the UK pension to the United States government, but not the United Kingdom.

In order to reduce the burden on such schemes, many governments give privately funded retirement plans a tax advantaged status in order to encourage more people to contribute to such arrangements. Governments often exclude such contributions from an employee's taxable income, while allowing employers to receive tax deductions for contributions to plan funds. Investment earnings in pension funds are almost universally excluded from income tax while accumulating, prior to payment. Payments to retirees and their beneficiaries also sometimes receive favorable tax treatment. In return for a pension scheme's tax advantaged status, governments typically enact restrictions to discourage access to a pension fund's assets before retirement.

In the United States, tax-advantaged retirement accounts include 401(k) plans, 403(b) plans, individual retirement accounts, and supplemental retirement accounts. These accounts have proliferated since they were introduced in 1978. As of 2015, they accounted for half of all long-term mutual fund assets.^[1]

Annuities

Investing in annuities may allow investors to realize tax advantages that are not realized through other tax-deferred retirement accounts, such as 401k and IRAs. One of the great advantages of annuities is they allow an investor to store away large amounts of cash and defer paying taxes. There is no yearly limit to contributions for annuities. This is especially useful for those approaching retirement age that may not have saved large sums throughout previous years. The total investment compounds annually without any federal taxes. This allows each dollar in the entire investment to accrue interest, which could potentially be an advantage compared to taxable investments. Additionally, upon cashing the annuity out, the investor can decide to receive a lump-sum payment, or develop a more spread out payout plan.

Education savings

Tax-advantaged savings accounts are designed to encourage saving for education expenses.^[2] In the United States, tax-advantaged savings vehicles include Coverdell education savings accounts and 529 plans.^[3]

Medical savings

In Singapore and other countries, medical savings accounts are tax-deferred.

Real estate

In order to encourage home ownership, there are tax deductions on mortgage payments.

In the United States, real estate investments yield considerable tax advantages.^[1] One benefit is the ability to regain the cost of income producing (for example, commercial real estate) properties through depreciation. When a property is bought in the United States, the cost of the building and land are capitalized. If the building is a commercial property or a rental property, used in a business, the cost of the building is depreciated over 39 years for non-residential buildings and 27.5 years for residential buildings using the straight-line depreciation method for tax purposes. The building's cost is written off over the lifespan of the building by annual depreciation deductions. Thus, the building owner receives these depreciation deductions as tax advantages at their income tax rate. Upon the sale of a property, depreciation recapture is the part of the gains that the depreciation deductions are responsible for during the period of ownership. The following is an example to show the idea of depreciation in a clear manner. A building owner buys a building for $20 million. After 5 years the owner has taken $1 million of depreciation deductions. Now, the building owner's basis in the building is $19 million. If the owner decides to sell the building for $25 million, the building owner will realize a gain of $6 million ($25 million less $19 million). Oftentimes people wrongly assume that this $6 million is taxed at a capital gains rate. However, this is a common misconception. In this example, $1 million of the gain would actually be taxed at the depreciation recapture rate, and the other $5 million at the capital gains rate.

In New Zealand, real estate investors receive a tax advantage. Investors can claim the mortgage interest they pay as a tax deduction, while homeowners cannot. This tax advantage subsidizes investors.^[4]

Life insurance

In the United States life insurance policies also have tax advantages. Income can grow in a life insurance policy that is tax deferred or tax-free. Additionally, there are certain advantages within certain life insurance policies that are excluded from estate and/or inheritance taxes.

Investments

Government bonds

In the United States, many government bonds (such as state bonds or municipal bonds) may also be exempt from certain taxes.

Investments in partnerships

Additionally, investments in partnerships and Limited Liability Companies also have tax advantages. For individual owners of businesses, the LLC is taxed as a sole proprietorship. This means that the entity is not taxed, but the income earned by the entity is taxed to the owner. The LLC has important tax advantages, such as the owners profits potentially being taxed at the owners lower marginal tax bracket. Furthermore, losses can offset the sole proprietor's non-business income. If there are multiple owners of a Limited Liability Company, there is also tax advantages associated with it. They can choose to be taxed as a partnership, but they can also decide to be taxed as a corporate-entity. Partnerships are not taxed, but corporations are. For LLCs taxed as partnerships the income is taxed to the partners. For a corporation or an LLC taxed like a corporation, the entity is subject to tax and dividends on after tax income are also taxed to the shareholders of the corporation or the members of the LLC.

Charitable giving

To encourage charitable donations from high net-worth individuals, there are tax deductions on charitable donations greater than a specified amount.^{[ vague ]}

Related Research Articles

In the United States, a 401(k) plan is an employer-sponsored, defined-contribution, personal pension (savings) account, as defined in subsection 401(k) of the U.S. Internal Revenue Code. Periodic employee contributions come directly out of their paychecks, and may be matched by the employer. This pre-tax option is what makes 401(k) plans attractive to employees, and many employers offer this option to their (full-time) workers. 401(k) payable is a general ledger account that contains the amount of 401(k) plan pension payments that an employer has an obligation to remit to a pension plan administrator. This account is classified as a payroll liability, since the amount owed should be paid within one year.

A pension is a fund into which amounts are paid regularly during an individual's working career, and from which periodic payments are made to support the person's retirement from work. A pension may be:

The Tax Reform Act of 1986 (TRA) was passed by the 99th United States Congress and signed into law by President Ronald Reagan on October 22, 1986.

An individual retirement account (IRA) in the United States is a form of pension provided by many financial institutions that provides tax advantages for retirement savings. It is a trust that holds investment assets purchased with a taxpayer's earned income for the taxpayer's eventual benefit in old age. An individual retirement account is a type of individual retirement arrangement as described in IRS Publication 590, Individual Retirement Arrangements (IRAs). Other arrangements include individual retirement annuities and employer-established benefit trusts.

A Roth IRA is an individual retirement account (IRA) under United States law that is generally not taxed upon distribution, provided certain conditions are met. The principal difference between Roth IRAs and most other tax-advantaged retirement plans is that rather than granting a tax reduction for contributions to the retirement plan, qualified withdrawals from the Roth IRA plan are tax-free, and growth in the account is tax-free.

A registered retirement savings plan (RRSP), or retirement savings plan (RSP), is a Canadian financial account intended to provide retirement income, but accessible at any time. RRSPs reduce taxes compared to normally taxed accounts. They were introduced in 1957 to promote savings by employees and self-employed people.

A 529 plan, also called a Qualified Tuition Program, is a tax-advantaged investment vehicle in the United States designed to encourage saving for the future higher education expenses of a designated beneficiary. In 2017, K–12 public, private, and religious school tuition were included as qualified expenses for 529 plans along with post-secondary education costs after passage of the Tax Cuts and Jobs Act.

In the United States, a 403(b) plan is a U.S. tax-advantaged retirement savings plan available for public education organizations, some non-profit employers (only Internal Revenue Code 501(c)(3) organizations), cooperative hospital service organizations, and self-employed ministers in the United States. It has tax treatment similar to a 401(k) plan, especially after the Economic Growth and Tax Relief Reconciliation Act of 2001. Both plans also require that distributions start at age 72 (according to the rules updated in 2020), known as Required Minimum Distributions (RMDs). Distributions are typically taxed as ordinary income.

A retirement plan is a financial arrangement designed to replace employment income upon retirement. These plans may be set up by employers, insurance companies, trade unions, the government, or other institutions. Congress has expressed a desire to encourage responsible retirement planning by granting favorable tax treatment to a wide variety of plans. Federal tax aspects of retirement plans in the United States are based on provisions of the Internal Revenue Code and the plans are regulated by the Department of Labor under the provisions of the Employee Retirement Income Security Act (ERISA).

A traditional IRA is an individual retirement arrangement (IRA), established in the United States by the Employee Retirement Income Security Act of 1974 (ERISA). Normal IRAs also existed before ERISA.

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Superannuation in Australia, or "super", is a savings system for workplace pensions in retirement. It involves money earned by an employee being placed into an investment fund to be made legally available to members upon retirement. Employers make compulsory payments to these funds at a proportion of their employee's wages. From July 2024, the mandatory minimum "guarantee" contribution is 11.5%, rising to 12% from 2025. The superannuation guarantee was introduced by the Hawke government to promote self-funded retirement savings, reducing reliance on a publicly funded pension system. Legislation to support the introduction of the superannuation guarantee was passed by the Keating Government in 1992.

A defined contribution (DC) plan is a type of retirement plan in which the employer, employee or both make contributions on a regular basis. Individual accounts are set up for participants and benefits are based on the amounts credited to these accounts plus any investment earnings on the money in the account. In defined contribution plans, future benefits fluctuate on the basis of investment earnings. The most common type of defined contribution plan is a savings and thrift plan. Under this type of plan, the employee contributes a predetermined portion of his or her earnings to an individual account, all or part of which is matched by the employer.

In the United States, an annuity is a financial product which offers tax-deferred growth and which usually offers benefits such as an income for life. Typically these are offered as structured (insurance) products that each state approves and regulates in which case they are designed using a mortality table and mainly guaranteed by a life insurer. There are many different varieties of annuities sold by carriers. In a typical scenario, an investor will make a single cash premium to own an annuity. After the policy is issued the owner may elect to annuitize the contract for a chosen period of time. This process is called annuitization and can also provide a predictable, guaranteed stream of future income during retirement until the death of the annuitant. Alternatively, an investor can defer annuitizing their contract to get larger payments later, hedge long-term care cost increases, or maximize a lump sum death benefit for a named beneficiary.

Under European Union law, an annuity is a financial contract which provides an income stream in return for an initial payment with specific parameters. It is the opposite of a settlement funding. A Swiss annuity is not considered a European annuity for tax reasons.

Tax deferral refers to instances where a taxpayer can delay paying taxes to some future period. In theory, the net taxes paid should be the same. Taxes can sometimes be deferred indefinitely, or may be taxed at a lower rate in the future, particularly for deferral of income taxes.

A life annuity is an annuity, or series of payments at fixed intervals, paid while the purchaser is alive. The majority of life annuities are insurance products sold or issued by life insurance companies however substantial case law indicates that annuity products are not necessarily insurance products.

Asset location (AL) is a term used in personal finance to refer to how investors distribute their investments across savings vehicles including taxable accounts, tax-exempt accounts, tax-deferred accounts, trust accounts, variable life insurance policies, foundations, and onshore vs. offshore accounts.

A tax-free savings account is an account available in Canada that provides tax benefits for saving. Investment income, including capital gains and dividends, earned in a TFSA is not taxed in most cases, even when withdrawn. Contributions to a TFSA are not deductible for income tax purposes, unlike contributions to a registered retirement savings plan (RRSP).

The National Pension System (NPS) is a defined-contribution pension system in India regulated by the Pension Fund Regulatory and Development Authority (PFRDA) which is under the jurisdiction of the Ministry of Finance of the Government of India. National Pension System Trust was established by PFRDA as per the provisions of the Indian Trusts Act of 1882 to take care of the assets and funds under this scheme for the best interest of the subscriber.

References

1 2 Simkovic, Michael (2015). "The Knowledge Tax". The University of Chicago Law Review. 82 (4): 2015–2018. JSTOR 43655478 . Retrieved 7 April 2021.
↑ Bogan, Vicki L. (2015). "Household Asset Allocation, Offspring Education, and the Sandwich Generation". The American Economic Review. 105 (5): 611–615. doi:10.1257/aer.p20151115. JSTOR 43821954 . Retrieved 7 April 2021.
↑ Dynarski, Susan (2004). "Who Benefits from the Education Saving Incentives? Income, Educational Expectations and the Value of the 529 and Coverdell". National Tax Journal. 57 (2): 359–383. doi:10.17310/ntj.2004.2S.01. JSTOR 41790219. S2CID 232212327 . Retrieved 7 April 2021.
↑ Smith, Clint (27 December 2020). "Jacinda Ardern is at her best in a crisis. Now she must tackle housing affordability". The Guardian. Retrieved 7 April 2021.

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[Simkovic-1] 1 2 Simkovic, Michael (2015). "The Knowledge Tax". The University of Chicago Law Review. 82 (4): 2015–2018. JSTOR 43655478 . Retrieved 7 April 2021.

[Bogan-2] Bogan, Vicki L. (2015). "Household Asset Allocation, Offspring Education, and the Sandwich Generation". The American Economic Review. 105 (5): 611–615. doi:10.1257/aer.p20151115. JSTOR 43821954 . Retrieved 7 April 2021.

[Dynarski-3] Dynarski, Susan (2004). "Who Benefits from the Education Saving Incentives? Income, Educational Expectations and the Value of the 529 and Coverdell". National Tax Journal. 57 (2): 359–383. doi:10.17310/ntj.2004.2S.01. JSTOR 41790219. S2CID 232212327 . Retrieved 7 April 2021.

[Smith-4] Smith, Clint (27 December 2020). "Jacinda Ardern is at her best in a crisis. Now she must tackle housing affordability". The Guardian. Retrieved 7 April 2021.

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