Looking for a great way to save on your tax bill while also contributing to your financial well-being? One of the best (and simplest) ways is to utilize accounts that reward you with tax breaks when you save for the future.
Here's the basic idea: pretty much everyone would benefit from saving for retirement, medical expenses, or paying for a child's education. But – let's be honest – it's a lot easier to prioritize the stuff that feels good right now than it is to save for later, so most people just don't do it.
However, it's a stressful burden on people's personal financial lives when they have to take on debt to pay for things like education, hospital bills, and retirement – and a drag on the U.S. economy as a whole. So Congress passed laws that encourage people to save for specific purposes by giving them tax breaks when they do so. It's a win-win: you feel better saving your money because of the tax break and the economy runs a little better because less people fall into debt.
These accounts make it easier to save on taxes in a variety of ways. Some reduce your current year taxable income when you contribute, some allow you to invest for many years then take out earnings (once certain conditions are met) tax-free, and all allow for any taxes on gains or dividends to be deferred as long as they are held within the account.
Saving in these tax-advantaged accounts also has a huge advantage over other tax strategies: they are simple & completely within your control. The IRS tax code is notoriously dense, and many of the methods that help you avoid taxes are fairly nuanced & complicated. Compared with determining a Qualified Business Income Deduction, whether to itemize or take the standard deduction, or the correct way to depreciate business assets, the mechanics & benefits of contributing to an IRA are a breeze.
Here are some of the most common tax-advantaged accounts that can help you save on your tax bill now and for years to come. (Please keep in mind that ALL of these accounts have penalties and potential tax consequences for taking money out at the wrong time or for the wrong reasons, so don't commit any money that you might need to cover an emergency or upcoming expense.)
Traditional IRA - probably the most common kind of tax-advantaged account, the Traditional Individual Retirement Account rewards you for setting aside money for retirement with a (potential*) tax deduction for contributions and no taxes on growth or dividends while held within the account. The trade off is that all distributions in retirement are treated as ordinary income and taxed accordingly. (*Note that anyone with earned income can contribute to a Traditional IRA, regardless of total income. However, the amount that is deductible is limited if you participate in a workplace retirement plan (like a 401(k) or SEP IRA) and make above a certain amount.) Pros: potential current year tax break, taxes deferred on growth & dividends; Cons: taxes owed upon withdrawal, penalties & taxes due for withdrawals before age 59 1/2.
Roth IRA - the Roth IRA is an interesting counterpoint to the Traditional IRA. Instead of giving you a current year tax break and then collecting taxes when you take money out in retirement, the Roth IRA gives you no current year benefit and instead allows for absolutely tax-free withdrawal of all gains & dividends during retirement. This is a great option for people in lower tax brackets (find your tax bracket here) or who anticipate having substantially higher income in retirement than now. Please note that Roth IRAs are intended to help people in lower tax brackets and eligibility phases out above certain income thresholds. Pros: taxes deferred on growth & dividends, qualified withdrawals tax-fee; Cons: no current year tax break, not available for high earners, potential penalties & taxes due for withdrawals before age 59 1/2.
HSA - Health Savings Accounts are designed for people with high-deductible health plans. Higher deductibles mean lower monthly insurance premiums, so the idea is that you take the money you saved on premiums and set it aside to help offset the burden of paying those deductibles out-of-pocket. HSAs have a completely unique triple tax advantage: contributions are deductible, taxes are deferred on any interest, growth, or dividends, and withdrawals for qualified medical expenses are tax-free. You really could take taxable income, put it in your HSA, spend that money to pay your health bills, and never pay taxes on it. Most HSAs require that you hold a certain amount in cash, but allow you to invest anything above that in things like index funds. Plus, after age 65 (when you have to sign up for Medicare and thus no longer have a high-deductible plan) you can take money out for non-medical expenses without penalties (though you still have to pay taxes on non-qualified withdrawals after age 65). Pros: a unique triple tax advantage, can essentially function as a Traditional IRA after age 65; Cons: limited investment choices, penalties & taxes due for non-qualified withdrawals.
529 Plan - these are plans that give preferential tax treatment to money set aside for education costs. 529 plans are state-administered and the deductibility of contributions varies state to state, but all of them allow for tax-deferred growth while assets are held in the account and tax-free withdrawals to pay for qualified education expenses. A super plus of 529 plans is that, even though they are state-administered, there is typically no requirement that the beneficiary (e.g., the person going to school) actually attend a school in that state. For example, you could live in North Carolina and, if your kid decides to go to school in Virginia, still use a 529 plan to pay for qualified expenses. Finally, while each account can only have one beneficiary and one owner, there is no reason that multiple people can't open different accounts for the same beneficiary. In other words, a child's parents could open & fund one account, the grandparents could open & fund another, a rich uncle could open & fund a third, etc. Pros: taxes deferred on growth & dividends, distributions for qualified education expenses tax-free, child does not need to go to an in-state school, multiple accounts with multiple owners for the same beneficiary; Cons: limited investment choices, deductibility of contributions varies state to state, potential penalties & taxes due for non-qualified withdrawals.
Have a question about your own accounts? Or interested in whether you can open & contribute to one of the accounts listed above? Hit me up – I'm always happy to answer questions.
Thanks,
Timothy Iseler, CFP®
Founder & Lead Advisor
Iseler Financial, LLC | Durham NC | (919) 666-7604
Iseler Financial helps creative professionals remove stress while taking control of their financial lives. We'll help identify your current strengths and weaknesses, clarify and refine your long-term goals, and prioritize decisions to improve your financial well-being now and later. Reach out today to take the first step.
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