Give Yourself a Tax Advantage

Derek Bostian, CFP® Derek Bostian, CFP®

If your income is pie, then the federal government takes a hefty slice each year. A 2020 report from the Tax Foundation found a single average wage earner in the United States pays about 29.8 percent of their income in federal taxes. That’s about $18,368 in federal taxes and does not include state and local taxes. The calculations include:1

  • Income tax 15.1 percent
  • Employee paid payroll taxes 7.1 percent
  • Employer paid payroll taxes* 7.6 percent

Payroll taxes fund Social Security and Medicare. 

If you would like to keep more of your income, tax-advantaged accounts can help. The category includes retirement, health, and education savings accounts, as well as savings accounts for people with disabilities. Here are a few you may want to learn more about:

  • Individual Retirement Accounts. Better known as IRAs, these accounts provide Americans with opportunities to reduce taxes while saving for retirement. There are different types of IRAs, including:2
  • Traditional IRAs. For instance, if you open and save in a Traditional IRA, your contributions may help reduce your taxes today. In addition, any earnings grow tax-deferred until you begin to take distributions which are typically taxed as ordinary income.

 

  • Roth IRAs. Alternatively, you could open and save in a Roth IRA. Roth IRAs don’t offer a current tax break. Contributions are taxed. However, distributions are tax-free, as long as certain conditions are met. In the meantime, any earnings grow tax-deferred. 

Not everyone can contribute to a Roth IRA. There are income limits that determine whether an individual or a household can make Roth contributions.

  • Rollover IRAs. If you have saved money in an employer’s workplace retirement plan and you retire or change employers, you may decide to rollover the savings into a Traditional or Roth IRA. A direct rollover from a workplace plan to a rollover IRA allows you to avoid taxes and keep your savings growing tax-deferred. 

No matter what type of IRA you choose, the tax advantages allow you to keep more of your money invested and compounding, so your savings can grow more quickly than it might in a taxable account. 

In 2020, anyone with earned income can contribute up to $6,000 to an IRA. If you’re over age 50, you can contribute an additional $1,000 for the year. While it’s possible to contribute to multiple IRAs, the maximum combined contribution cannot exceed these limits.3

  • Workplace retirement savings plans. Your employer may make it possible for you to save in a qualified retirement plan such as a 401(k), 403(b), SIMPLE, or SEP IRA plan. 

Contributions made to these plans offer tax-advantages that may include tax-deductions today or tax-free income tomorrow, in addition to tax-deferred growth of any earnings.4

In general, you can contribute far more to a workplace plan than you can to an IRA. For example, in 2020, the maximum annual contribution to a: 

  • 401(k) plan is $19,500. Employees who are age 50 or older can save an additional $6,500.5
  • 403(b) plan is $19,500. Employees who are age 50 or older can save an additional $6,500.5
  • SIMPLE IRA plan is $13,500. Employees who are age 50 or older can save an additional $3,000.6
  • SEP IRA plan is 25 percent of compensation, up to $57,000.7

Some employers match employee contributions. So, when an employee contributes to the plan, the employer contributes, too. Tax-advantages can help you save more than you might otherwise.4

  • Health savings accounts. Healthcare is likely to be a significant expense in retirement for most Americans. Fidelity estimated a 65-year old couple retiring in 2020 will need approximately $295,000 to pay for healthcare and medical expenses during retirement.8

Health Savings Accounts, also known as HSAs, offer a tax-advantaged way to pay for healthcare expenses today and save for future healthcare costs. Don’t confuse HSAs with Flexible Spending Accounts (FSAs). Typically, money in an FSA must be used during the plan year or it is lost. Any money saved in an HSA is yours forever.9, 10

Anyone enrolled in a high-deductible health insurance plan can save in an HSA. Some employers offer HSA accounts, others do not. If an employer doesn’t offer an HSA, you can open one on your own. You can save in an HSA until age 65, even if you are not working.10

HSAs offer a triple tax advantage:10

  1. Contributions are pre-tax if they are made through payroll deductions or tax-deductible if you contribute to an account you open. Either way, they provide a tax break today.
  1. Any earnings grow tax-deferred so the accounts have the potential to grow faster than taxable accounts.
  1. Distributions taken to pay qualified medical expenses are tax-free.

In general, individuals with single coverage through a qualifying high-deductible health plan can contribute up to $3,550 in 2020. A household with family coverage may contribute up to $7,100. Anyone age 55 or older can contribute an additional $1,000 in catch-up contributions during 2020.10

  • Education savings plans. Another way to reduce taxes is to save elementary, secondary, or college expenses in a 529 college savings plan. Typically, 529 plans are offered by states and offer a variety of tax incentives, including:11
  • Current tax deductions. Contributions to 529 plans are not federally tax-deductible, but they often are state tax deductible for state residents.
  • Tax-deferred growth of any earnings in 529 plan accounts.
  • Tax-free distributions when used to pay qualified education expenses. 

Anyone can contribute to a 529 plan – parents, grandparents, family, friends – and there are no annual contribution limits. That said, contributions to 529 plans are considered to be completed gifts for federal tax purposes. For 2020, the gift tax exclusion for individual gifts is $15,000. So, a couple with two children could gift $60,000 ($15,000 each for two children) without gift tax consequences.12

There may also be benefits to making larger contributions. When a donor makes “…a contribution of between $15,000 and $75,000 for a beneficiary, you can elect to treat the contribution as made over a five calendar-year period for gift tax purposes. This allows you to utilize as much as $75,000 in annual exclusions to shelter a larger contribution. The money (and the growth of your account) gets out of your estate faster than if you made contributions each year,” reported Saving for College.12

  • 529 ABLE accounts. The 2014 ABLE Act makes it possible for Americans with disabilities, that were identified (before they reached age 26) and their families, to set aside savings in tax-deferred accounts. The money can be used as a supplement to private insurance and public benefits.13

ABLE accounts are similar to 529 education savings accounts in that the annual contribution often is determined by the maximum annual gift tax exclusion. However, when an account reaches $100,000 the beneficiary may no longer be eligible for Social Security Disability benefits.14

When it comes to investing, it’s not how much you earn that matters. It’s how much you keep. If you would like to learn more about tax-advantaged investment opportunities, get in touch.

*The Tax Foundation calculations include payroll taxes paid by employers because, “…economists generally agree that the burden of both sides of the payroll tax falls on workers.”

Sources:
1 https://taxfoundation.org/us-tax-burden-on-labor-2020/
2 https://www.fidelity.com/building-savings/learn-about-iras/what-is-an-ira
3 https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits
4 https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits
5 https://www.irs.gov/newsroom/401k-contribution-limit-increases-to-19500-for-2020-catch-up-limit-rises-to-6500
6 https://www.irs.gov/retirement-plans/how-much-can-i-contribute-to-my-self-employed-sep-plan-if-i-participate-in-my-employers-simple-ira-plan
7 https://www.irs.gov/retirement-plans/plan-participant-employee/sep-contribution-limits-including-grandfathered-sarseps
8 https://www.fidelity.com/viewpoints/personal-finance/plan-for-rising-health-care-costs
9 https://www.healthcare.gov/have-job-based-coverage/flexible-spending-accounts/
10 https://www.irs.gov/pub/irs-pdf/p969.pdf
11 https://www.savingforcollege.com/intro-to-529s/name-the-top-7-benefits-of-529-plans
12 https://www.savingforcollege.com/intro-to-529s/are-there-gift-and-estate-tax-benefits-for-529-plans
13 https://www.irs.gov/pub/irs-pdf/p907.pdf
14 https://www.ablenrc.org/what-is-able/what-are-able-acounts/
This material was prepared by Carson Coaching. Carson Coaching is not affiliated with the named broker/dealer or firm.
In general, a distribution from a Roth IRA is tax-free and penalty-free, as long as the account has been open for five years and the account owner is age 59½, has become disabled, is making a qualified first-time home purchase ($10,000 lifetime limit), or dies. Minimum required distributions do not apply to the original account owner, although they may apply to heirs.
Prior to investing in a 529 Plan, investors should consider whether the investor’s or designated beneficiary’s home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state’s qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary.
Before investing in an ABLE plan, consider whether your state offers an ABLE program that provides residents with favorable state tax benefits. ABLE accounts may be protected from creditors if you invest in your own state’s program, depending on the state.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing.
This is not intended to be a substitute for specific individualized tax advice. We suggest you discuss your specific tax issues with a qualified tax professional.
Derek Bostian, CFP®