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Tax advantage refers to the economic bonus which applies to certain accounts or
investment Investment is the dedication of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort. In , the purpose of investing is to generate a from the inve ...

investment
s that are, by
statute A statute is a formal written enactment of a legislative A legislature is an assembly Assembly may refer to: Organisations and meetings * Deliberative assembly A deliberative assembly is a gathering of members (of any kind of collective) ...

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

In essence building tax advantages into the law is providing a government subsidy for engaging in this behavior. Obviously encouraging people to save for retirement is a good idea, because it reduces the need for the government to support people later in life by spending money on welfare or other government expenses for these people, but does a capital gains tax rate benefit spur investment? Should capital gains tax benefit be limited to direct investments in businesses and not to the secondary capital markets (because they don't provide financing for growing businesses)?


Types of tax-advantaged accounts and investments


Retirement plans

An example is
retirement plan A pension (, from Latin Latin (, or , ) is a classical language belonging to the Italic languages, Italic branch of the Indo-European languages. Latin was originally spoken in the area around Rome, known as Latium. Through the power of the ...
s, which often offer tax advantages to incentivize
saving Saving is income In microeconomics, income is the Consumption (economics), consumption and saving opportunity gained by an entity within a specified timeframe, which is generally expressed in monetary terms.Smith's financial dictionary. Smit ...
for
retirement Retirement is the withdrawal from one's position or occupation or from one's active working life. A person may also semi-retire by reducing work hours or workload. Many people choose to retire when they are old or incapable of doing their job d ...

retirement
. In countries in which the average age of the population is increasing, tax advantages may put pressure on
pension A pension (, from Latin Latin (, or , ) is a classical language A classical language is a language A language is a structured system of communication Communication (from Latin ''communicare'', meaning "to share" or "to be ...

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 United States of America (U.S.A. or USA), commonly known as the United States (U.S. or US) or America, is a country Continental United States, primarily located in North America. It consists of 50 U.S. state, states, a Washington, D.C., ...

United States
, the rapid onset of
Baby Boomer Baby boomers (often shortened to boomers) are the demographic Demography (from prefix ''demo-'' from Ancient Greek Ancient Greek includes the forms of the Greek language used in ancient Greece and the classical antiquity, ancien ...
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 fund A pension fund, also known as a superannuation fund in some countries, is any plan, fund, or scheme which provides pension, retirement income. Pension funds typically have large amounts of money to invest and are the major investors in listed an ...
s are almost universally excluded from
income tax An income tax is a imposed on individuals or entities (taxpayers) in respect of the income or profits earned by them (commonly called ). Income tax generally is computed as the product of a tax rate times the taxable income. Taxation rates may v ...
while accumulating, prior to payment. Payments to
retiree A pensioner is a person who receives a pension A pension (, from Latin Latin (, or , ) is a classical language belonging to the Italic languages, Italic branch of the Indo-European languages. Latin was originally spoken in the area around ...
s and their
beneficiaries A beneficiary (also, in trust law A trust is a legal relationship in which the holder of a right (eg. title to a chattel) gives it to another person or entity who must keep and use it solely for another's benefit. In , the party who entrusts t ...
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) In the United States, a 401(k) plan is an employer-sponsored defined-contribution pension A pension (, from Latin Latin (, or , ) is a classical language belonging to the Italic languages, Italic branch of the Indo-European languages. Lat ...
plans,
403(b) In the United States The United States of America (USA), commonly known as the United States (U.S. or US), or America, is a country Contiguous United States, primarily located in North America. It consists of 50 U.S. state, states, a Washing ...
plans,
individual retirement account An individual retirement account (IRA) in the United States is a form of "individual retirement plan", provided by many financial institutions, that provides tax advantage Tax advantage refers to the economic bonus which applies to certain accounts ...
s, 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.


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. In the United States, tax-advantaged savings vehicles include Coverdell education savings accounts and
529 plan A 529 plan 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 ...
s.


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. 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.


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 The United States of America (U.S.A. or USA), commonly known as the United States (U.S. or US) or America, is a country Continental United States, primarily located in North America. It consists of 50 U.S. state, states, a Washington, D.C., ...

United States
, many
government bond A government bond or sovereign bond is an debt obligation issued by a national government to support government spending Government spending or expenditure includes all government consumption, investment, and transfer payments. In national ...
s (such as
state State may refer to: Arts, entertainment, and media Literature * ''State Magazine ''State Magazine'' is a digital magazine published by the U.S. Department of State's Bureau of Global Talent Management. Its mission is to acquaint Department o ...
bonds or
municipal bond A municipal bond, commonly known as a muni, is a bond Bond or bonds may refer to: Common meanings * Bond (finance) In finance Finance is the study of financial institutions, financial markets and how they operate within the financial sys ...
s) may also be exempt from certain
tax A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal entity In law Law is a system A system is a group of Interaction, interacting or interrelated elements that act accord ...
es.


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.


See also

*
Asset locationAsset location (AL) is a term used in personal finance Personal finance is the financial management which an individual or a family unit performs to budget, save, and spend monetary resources over time, taking into account various financial ris ...
*
Tax avoidance and tax evasion Tax noncompliance (informally tax avoision) is a range of activities that are unfavorable to a government's tax system. This may include tax avoidance, which is tax reduction by legal means, and tax evasion which is the criminal non-payment of tax ...


References

{{Tax-stub Tax incidence