What is a tax advantaged account?
A tax advantaged account is any type of savings plan that is either:
- Exempt from taxation (you will not pay any taxes). This is what we would refer to as a tax free savings account
- Taxes are deferred (you will get a tax deduction now, but pay the taxes later, e.g. upon retirement)
- Taxes are paid upfront, but funds will not be subject to further taxation in the future if tax rates increase
- Offers other types of tax benefits (such as tax-free interest or tax-free investment income within the account)
These types of accounts are very useful for tax savings and tax planning purposes.
What are the types of tax-advantaged accounts?
There are many different kinds of tax-advantaged accounts. We will be discussing only the most popular accounts:
- Health savings accounts for medical expenses
- Tax-deferred retirement accounts
- Post-tax retirement accounts
- Education funds
- Private deferred compensation plans
Health savings accounts for medical expenses
Health Savings Account (HSA)
Maximum 2021 contribution: $3,600 for individual coverage or $7,200 for family coverage
Healthcare costs in the US can be through the roof, and health insurance is expensive. An HSA is a tax advantaged account that allows you to claim deductions for qualified medical expenses (excluding premiums), such as co-pays, out-of-pocket medical expenses, deductibles, prescriptions, certain procedures (chiropractic, physical therapy), and even some over-the-counter medications.
You can set up an HSA account on your own, even if your employer does not offer one.
Possible tax savings annually can reach $3,000 annually or more.
There are a few caveats.
To qualify, you have to:
- Have a high-deductible, HSA eligible, health plan (health insurance plan)
- You cannot have both an HSA and FSA
- You cannot be enrolled in Medicare
- You cannot be claimed as a dependent on someone else’s tax return
Other benefits of an HSA are:
- Your contributions, if unused, roll over to subsequent years. You do not lose your funds!
- Funds in a health savings account can be invested and collect interest, and grow tax free!
- If you manage to accumulate a larger sum in your health savings account, you can use the funds for long-term care or a large medical procedure, so strategize accordingly!
- Money is tax-free going in, and – if spent on qualified medical expenses – tax free going out.
We highly recommend setting up an HSA if you are eligible, both to lower your tax burden and to have an emergency healthcare fund.
Flexible Saving Arrangement (FSA)
Maximum 2021 contribution: $2,750
Health FSAs are employer-established benefit plans (these types of benefits are often called “cafeteria plans”), which means you cannot set up an FSA on your own, or if you are self-employed.
At the beginning of each plan year, you select an amount that will be withheld from your paycheck periodically (e.g. with every paycheck). Your employer can also contribute to your FSA.
The funds you contribute to your FSA yourself are federal income tax free and employment tax free.
Here are the pros of an FSA:
- Your employer can also make contributions to your FSA.
- Money you put into an FSA is tax free, if spent on eligible expenses
- In 2021, you can contribute up to $2,750
- You do not need a high deductible health insurance plan to qualify
Here are the cons of an FSA:
- Unused contributions within an FSA are usually forfeited at the end of the year (with some exceptions)
- Money cannot grow in an FSA, nor can it be invested
- You cannot have an FSA in conjunction with an HSA
- Plans that cover highly compensated employees and key employees may have restrictions
- You cannot set up an FSA on your own – it must be employer sponsored
- You cannot use funds in your FSA to pay for health insurance premiums, long-term care coverage or expenses, or amounts that are covered under another health plan.
Tax-deferred retirement accounts
Retirement planning usually includes contributions made in pre-tax dollars, i.e. to tax-deferred retirement accounts.
A tax deferred retirement account means you are not paying taxes on contributions now – but will be paying taxes in the future, when you retire. As such, these plans do not reduce your taxes – they just defer your taxes.
Below are the most popular types of tax-deferred retirement accounts:
1. Traditional 401(k) plan
Maximum 2021 contribution for persons under the age of 50: $19,500
A 401(k) is a plan that allows employees to contribute a portion of their wages to individual retirement accounts.
- If you choose to participate, contributions are not included in your taxable income
- An employer may contribute to employees’ accounts (i.e. “match”)
- Distributions, including any earnings within the 401(k), are taxable upon retirement
- You are required to take minimum distributions from your 401(k) when you reach the age of 72, (or 70 and 1/2 if you reached the age of 70 and 1/2 before January 1st, 2020).
Maximum 2021 contribution for persons under the age of 50: $19,500
A 403(b) plan (also called a tax-sheltered annuity or TSA plan) is a retirement plan offered by public schools, churches and certain tax-exempt organizations, such as not-for-profit hospitals. It is the equivalent of 401(k) plans offered by for-profit businesses.
- Employees save for retirement by contributing to individual accounts through salary deferrals. Deferred salary is not subject to federal or state income taxes, until distributions are taken.
- Employers can also contribute to employees’ accounts.
- Funds in a 403(b) can be invested – though investment options are limited and chosen by the employer
- Employees may be able to take out loans or hardship distributions
3. Traditional IRA
Maximum 2021 contribution: $6,000
If your employer does not offer any retirement options, you may want to investigate setting up a traditional IRA.
Your contributions may be fully or partially tax deductible and are generally not taxed until you take a distribution upon retirement.
In 2021, you can contribute up to $6,000 ($7,000 if you’re age 50 or older) to all traditional and Roth IRA accounts combined.
4. SEP IRA
Maximum 2021 contribution: 25% of compensation, but not more than $58,000
Simplified Employee Pension (SEP) plans can provide a significant source of income at retirement by allowing employers to set aside money in retirement accounts for themselves and their employees.
A SEP can be set up by a business of any size. Only employers can make contributions. Contributions can be up to 25% of each employee’s (or business owner’s) pay.
A SEP offers a tax deferral – you will not pay taxes until you start taking contributions upon retirement.
5. SIMPLE IRA
Maximum 2021 contribution: $13,500
A SIMPLE IRA plan (Savings Incentive Match PLan for Employees) allows both employers and employees to contribute to traditional IRAs set up for employees. This type of plan is best suited for smaller companies that do not offer any other retirement plan.
Contributions are made in pre-tax dollars and can be matched (up to 3%) by the employer. Distributions upon retirement are taxable in the year they are taken.
Eligible employees can receive a 3% or 2% match by their employer. To be eligible, an employee must have earned at least $5,000 in any two years before the current calendar year AND expect to receive at least $5,000 during the current calendar year.
The amount an employee contributes from their salary to a SIMPLE IRA in 2021 cannot exceed $13,500, and salary-reducing contributions to all plans in 2021 cannot exceed $19,500.
After-tax retirement accounts
Depending on your age, you may have 30 or even 40+ years until you retire. Today, the highest federal tax bracket is 37%. What will your tax bracket be when you retire? Many experts feel that taxes will end up eating at least 50% of our retirement savings. This means that if you currently have a million dollars in a 401(k) – you might have to give half of that to the IRS.
This is why many people supplement their tax-deferred retirement savings with retirement savings made in after-tax dollars. Because you are using after-tax dollars for contributions, you will NOT pay taxes a second time when taking distributions in retirement.
The most popular after tax retirement accounts are Roth IRAs.
Maximum 2021 contribution: $6,000
Contributions to a Roth IRA are made in post-tax dollars. Here you are betting that your tax rate upon retirement will be higher than your current rate. Experts agree that given the pandemic and stimulus bills, taxes have nowhere to go but up!
Contributions to a Roth IRA are not tax deductible, but money is allowed to grow tax free, and can be invested tax free.
At the age of 59 and 1/2, you can start taking tax-free distributions from your Roth.
The downsides of a Roth IRA?
- A $6,000 annual contribution limit (or $7,000 if you are 50 years old or over)
- To contribute to a Roth in 2021, your modified adjusted gross income (MAGI) must not exceed $140,000 for single taxpayers, or $208,000 if married and filing jointly.
- If your MAGI is more than $125,000, but less than $140,000, you can contribute a reduced amount to a Roth
- At times, there are ways around these caps – a so-called backdoor Roth IRA.
Why do we love Roths?
- Interest and investments grow tax free – and can reach billions!
- Your distributions are tax-free upon retirement
- No required minimum distributions
- You may qualify for a Saver’s Tax Credit
Maximum 2021 contribution: $19,500
A Roth 401(k) is an employer-sponsored retirement savings account that is funded with after-tax dollars. If you believe that income tax rates will increase in the future – this might be the solution for you.
Some businesses offer both a traditional 401(k) and Roth 401(k) option. Combined contributions to these accounts cannot exceed $19,500 annually (as of 2021).
Unlike with a Roth IRA, there are no income restrictions on Roth 401(k) eligibility.
Eligible withdrawals (after you reach the age of 59 and a half) can be taken tax free.
College and education plans
As we all know, a college education can be VERY expensive, and it is always a good idea to open a college savings account if you can afford to. Thankfully, some college and education savings accounts offer additional tax advantages.
According to the US Securities and Exchange Commission, a 529 plan is a “tax-advantaged savings plan designed to encourage saving for future education costs. 529 plans, legally known as “qualified tuition plans,” are sponsored by states, state agencies, or educational institutions and are authorized by Section 529 of the Internal Revenue Code”.
Here are the main pros of a 529 plan:
- Funds within the plan can grow federal-tax free
- Funds used for eligible purchases (such as college tuition) are also not taxed
- Your state might offer state benefits, such as full or partial tax deduction or tax credit
Private Deferred Compensation Plan: Whole life insurance
Maximum 2021 contribution: no maximum
Money in a 401(K), or equivalent, is not tax FREE – just tax DEFFERED. This means you will pay taxes on 401(K) retirement funds – as you take distributions upon retirement.
What will your tax rate be when you retire in 10, 20, or 30 years? No one can know that – but most experts expect tax rates to go up.
This is why retirement plans made in post-tax dollars, such as a Roth IRA, are becoming more and more popular, as distributions upon retirement will be tax free.
In addition, traditional retirement plans have contribution limits, income limits, and a minimum distribution age, i.e. how old you have to be before you can start taking money out without incurring penalties.
A whole life insurance policy can circumvent all these limitations, though your contributions (premiums) are made with post-tax dollars.
This type of account may** offer:
- Tax preferred cash accumulation
- No contribution limit
- Baseline, guaranteed cash accumulation
- Potential (not guaranteed!) dividends* that add to your cash accumulation
- Ability to take tax-preferred withdrawals in retirement
- A custom policy to meet your needs**
- An income tax free death benefit (if eligible!!)
- You can add bells and whistles, such as:
- A disability waiver rider
- A long-term care rider
- A term life insurance policy
*Dividends are not guaranteed
**Whole life insurance plans are medically underwritten – and are not available to all applicants.
Please see complete policy illustration before making any decisions!