Tax advantage

Tax advantage

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. The most obvious examples are Retirement plans, but investments in many state or municipal bonds can also be exempt from certain taxes. Governments establish the tax advantaged status of these investments to encourage private individuals to contribute money when it is considered to be in the public interest.

In many countries, the average age of the population is increasing. This can 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 U.S., the rapid onset of Baby Boomer retirement is currently causing such a problem.)

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.

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