What it is:
How it works (Example):
One of the best examples of tax-advantaged investing is the 401(k) plan. Offered by employers, 401(k)s allow employees to put pre-tax dollars in their retirement accounts. The primary tax advantage is that employees contribute to the retirement plan with money that hasn't been hit with payroll taxes yet. Furthermore, any taxable events (like dividend and interest payments) that happen inside the 401(k) account are protected from taxation.
So, for example, if your salary is $1,000 a week and your tax rate is 25%, your after-tax income would be $750. If you put $200 of that after-tax money in a savings account, you are left with $550 to pay the rest of your bills.
But a tax-advantaged strategy would be to put $200 in your 401(k). Here’s how the math works out:
- Gross earnings: $1,000
- 401(k) contribution (made pre-tax): $200
- Net earnings: $800
- Tax rate: 25%
- Take-home pay: $600
In the second scenario, you'd still make $1,000, still save $200 (in a 401(k) account), but have $600 left over -- that is, you'd end up with an extra $50. That's why tax-advantaged investing is so important to individual investors.