The U.S. tax code is filled with a mind-boggling array of tax-avoidance tools including tax-friendly accounts, loopholes, and special favors to various constituents.
The primary intent of the tax code is to collect money, but the politicians who shape it add in a bunch of cheats and easter eggs that lower the amount of tax they collect.
The tax code has become less about collecting revenue and more of a vehicle to legislate. Politicians give tax advantages to certain people (i.e. the poor) or behavior (i.e. saving for retirement, installing solar panels) because the action reflects their values or they believe it’s good for the country.
After all the credits and tax breaks are sorted out, the revenue collected pays for government operations, defense, debt obligations (#notawesome), and programs previously legislated by past politicians.
Changing anything is difficult. So any new taxes, tax cuts, or new government programs are added on top of what already exists, making the whole mess more complicated. Few tax laws or government programs are ever completely eliminated.
Most of us can agree on a few things:
- The taxation process should be much simpler
- We individually want to give less money to the government
- Huge amounts of taxpayer dollars are spent in ways we don’t like
- The money we pay to government should be spent fairly* and wisely**
* Impossible to define ** Rarely happens
This time of the year, Americans should remember to not hate the IRS (Internal Revenue Service). Congress writes the tax laws. The IRS is the responsible organization to collect taxes and enforce the laws. The IRS asks that you pay ever dollar you owe. Not one dollar more or one dollar less.
So if you don’t like taxes, blame Capitol Hill, not Constitution Avenue.
But what you owe is wildly variable based on your planning and decisions.
You can whine about taxes and what politicians do with them. Or you can take some personal responsibility and figure out how to lower the taxes you pay.
To help, I’ve compiled a list of 15+ tax-friendly accounts that can lower your tax liability.
This list probably isn’t complete, and certainly, doesn’t scratch the surface of all the loopholes in the tax code. The more complicated your tax situation is, the more advantages a good CPA*** can find.
I was surprised at how many types of accounts there are, most of which accomplish the same thing.
Seeing the redundancy and sloppiness of our tax code is motivation to use these accounts keep more of your money out of the hands of the people making this stuff up.
*** I am not a CPA
15+ Tax-Friendly Accounts To Help You Keep More of What You Earn
Paying our fair share of taxes and embracing all the government provides to us is as American as apple pie.
So is tax avoidance (not to be confused with tax evasion… illegally not paying taxes).
Here’s a list of 15+ tax-friendly accounts you may be able to use to lower your taxable income or future tax liabilities.
Employer Sponsored Traditional 401(k) Plan
A lot of us working for an established employer have the option to participate in a traditional 401(k) plan. For this account, money is withheld from a paycheck and deposited into a third-party account (an administrator). The money is usually invested in a select group of mutual funds or index funds established in the plan.
The funds are deposited pre-tax, meaning your federal tax is determined after this money is taken out. So if you save $500 into your 401(k) plan, you don’t pay federal or state taxes on that money. You will still pay Social Security and Medicare taxes (FICA) on it.
The investments grow free of capital gains or dividend taxes. The money is taxed when it’s withdrawn, and generally, cannot be withdrawn without penalty until age 59 1/2 (with some exceptions).
Read more: 3 Signs You Have a Crappy 401(k) Plan
Traditional IRA (Individual Retirement Account)
Traditional IRAs work in a similar fashion to 401(k) plans in that money is deposited pre-tax, lowering your federal and state taxes. Investments grow tax-free until withdrawal at age 59 1/2 (at which point the money is taxed). Participates can deposit up to $5,500 (2017) pre-tax, but only if your employer does not offer a 401(k) or another similar plan. Some deduction limits apply.
IRAs are not administered through an employer, so the participate must open an IRA with an online broker such as Fidelity, Vanguard, TD Ameritrade, TradeKing, or even with a peer to peer lending site like LendingClub.
You’ll often hear the term rollover IRA. This is simply a way to move your 401(k) money into a traditional IRA without fees or penalties. You can only do a rollover once you leave your job. This is a good idea because you’ll have a better selection of investments, especially if your 401(k) plan sucks.
The Roth IRA was championed by the late Senator William V. Roth, Jr. and established in the Taxpayer Relief Act of 1997.
Roth IRA accounts are also opened through a broker like its traditional counterpart. However, contributions are made after-tax, that is, after everything has been taken out of your paycheck. Funds can be invested in a variety of investments (stocks, funds, bonds, ETFs, etc), and the investments also grow tax-free.
The contribution limit is $5,500 like the traditional IRA. One major difference with a Roth is that contributions made to the account can be withdrawn tax and penalty-free before age 59 1/2. But earnings on that money cannot be withdrawn. So for example, if you contribute $5,500 one year and it grows to $6,500 after two years, the original $5,500 can be withdrawn without penalty or tax at any time.
Another important difference is that after age 59 1/2, all withdrawals are made tax-free.
Single filers with an adjusted gross income over $133,000 (and $196,000 for joint filers) for 2017 cannot contribute to a Roth IRA.
Read more: Utilize the Roth IRA for Early Retirement
529 College Savings
529 college savings plans allow parents or other concerned adults to save for a child’s college education. The plans were established in the Internal Revenue Code, however, 529 plans do not help you avoid federal taxation. 529 can lower your state taxes.
The plans come in two forms. Prepaid plans and savings plans.
Prepaid plans allow the parent or guardian to pay today’s tuition rates for future enrollment.
Savings plans give tax advantages similar to a traditional IRA in that you can contribute pre-tax money and it grows tax-free and can be withdrawn tax-free, as long as it is used for an eligible child for higher education. The pre-tax benefits only lower state tax liability, not federal.
Each state creates and designs their own rules and benefits. But often the plans are administered by mutual fund companies or online brokers.
The Kay Bailey Hutchison Spousal IRA was created to allow non-working spouses to contribute to retirement savings.
The Spousal IRA can be either a traditional or a Roth-style IRA and is created by opening an account at your favorite online broker. In fact, the Spousal IRA is no different than the traditional and Roth IRAs. The significance distinction is prior to 1996, they were not allowed for stay at home parents who work their asses off, but don’t get paid.
Mrs. RBD stays at home and has a Spousal Roth IRA. It’s doubled our Roth savings every year.
HSA (Health Savings Account)
A Health Savings Account is available to people with certain health insurance plans known as high-deductible plans. The account allows the account holder to put aside some pre-tax or tax-deductible money to help pay for eligible medical expenses. Employers may also contribute to these accounts.
The policy holder typically receives a debit card to use for expenses and is required to submit receipts to make sure expenses are qualified. Unused balances roll over to the next year. There’s a lot of nifty retirement-friendly attributes of these accounts.
The HSA has become a favorite account for earlier retirees for its flexibility, tax-free growth, and tax-free withdrawals. Its use as a “super IRA in disguise” was popularized by blogger the Mad Fientist (see below).
Read more: HSA – The Ultimate Retirement Account
FSA (Flexible Spending Account)
The Flexible Spending Account is similar to an HSA as a tax-advantaged health insurance related account. It’s irritating that something so similar to the HSA, with a similar name, but still different exists. This confuses people trying to figure out what’s best for their families.
FSA’s are available through employers as a way for employees to pay for eligible medical expenses with pre-tax money. The FSA is distinguished from the HSA in that they can be used with non-high deductible plans. Also, funds leftover at the end of the year are considered use it or lose it, meaning if you don’t spend it, it disappears. So good planning is essential.
Account holders still need to keep track of receipts and use a debit card for spending. I had one of these accounts for a period of time and felt the tax savings wasn’t worth the hassle. I hated it, especially since it didn’t have the super powers of an HSA.
The Roth 401(k) combines parts of both the traditional 401(k) and the Roth IRA. Some employers choose to sponsor these plans in additional to the traditional 401(k). It functions like a Roth IRA in that contributions are made after-tax, grow tax-free, and are withdrawn tax-free after the age of 59 1/2. The Roth 401(k) made its first appearance in 2006.
I prefer the pre-tax traditional 401(k) format so I can lower my tax liability in the current paycheck and year. However, for people that expect higher taxation of their income in retirement, the Roth 401(k) may be a better option.
Thrift Savings Plan (TSP)
The Thrift Savings Plan was established in 1986 for federal workers and military members of the U.S. government. It functions essentially the same as a traditional 401(k) plan, and as of 2012, a Roth 401(k), but is administered by an entity called the Federal Retirement Thrift Investment Board.
Participants have five funds and five “Lifecycle” (age-based revolving) funds to choose from. The government provides limited matching and the matched funds become vested after three years of federal service.
The 403(b) is another plan very similar in structure to the 401(k). Contributions are made pre-tax, investments grow tax-free, and the same limits apply. But these are typically offered to teachers and public education workers, as well as some non-profit workers.
My Dad was a teacher and contributed to his 403(b) during his career. Once he retired he rolled it into a traditional IRA with a broker.
The Solo 401(k) is designed for self-employed workers. Also known as a Self-Employed 401(k) and an Individual 401(k), it’s a powerful retirement tool for full or part-time entrepreneurs. It effectively allows contributions as both an employee and as an employer.
Meaning, a participate can contribute the standard 401(k) limit (currently $18,000 for 2017), but also up to 25% of the participant’s self-employed income, up to a combined total maximum of $53,000. For self-employed contractors, this is some serious tax-friendly juice. One notable blogger deploying this strategy is Mr. 1500 (see below).
Read more: 9 Ways To Make Your 401k Suck Less
This is like a 401(k), but available to certain governmental and non-governmental employers (no idea what that means!). The main difference from a 401(k) is that there is no early withdrawal penalty before age 55, and withdrawals are taxed as ordinary income.
Self-Directed IRAs function like a traditional IRA but allow for riskier investments. These are mostly used as a way to use retirement savings to invest in real estate, precious metals, or other non-traditional investments.
For example, a retiree can roll over his/her 401(k) into a self-directed IRA and buy a rental property for income. This isn’t allowed in a traditional IRA at Fidelity or elsewhere.
ESA Coverdale (Education Savings Account)
The ESA Coverdale account is another vehicle for saving for a child’s education. It offers tax-free earnings growth and tax-free withdrawals, but no tax deductions on the state or federal level. The other main difference between the ESA Coverdale and the 529 is the Coverdale can be used for K-12 expenses. There’s also lower limits on annual maximum investments ($2,000 per beneficiary per year in 2016). Also, there are income limits on contributors.
A few more…
- SEP IRA (Simplified Employee Pension) – A lower cost IRA option for business owners.
- SIMPLE IRA (Savings Incentive Match Plan for Employees) – A simpler and lower fee type of employer-sponsored tax-deferred plan, similar to a 401(k) or IRA with lower contribution limits.
- SIMPLE 401(k) (Savings Incentive Match Plan for Employees) – Again, simpler and less costly, meant for employers with less than 100 employees. Odd that the minor variations between the two are even necessary.
- 401(a) – Funny, I left this off the original list because I thought who the hell has a 401(a)? Then last week, a recruiter called me and they had a 401(a). It’s similar to a 401(k) for certain governmental agencies (in my case) educational or non-profits.
The same politicians who created these accounts to allow us to avoid some taxation could always eliminate, modify, reorganize, or add more to this ridiculous list of accounts. At one time, the idea of one retirement savings account (RSA) and one education savings account (ESA) was floated (maybe even a law drafted?) to simplify things. But I haven’t heard about it in years.
The possibility is always out there that our money isn’t quite protected from Uncle Sam because the politicians can change their minds. That’s unlikely for the political uproar it would cause.
And it’s possible they could drastically simplify the tax code and retirement and education savings accounts. But let’s not hold our breath.
The savings vehicles are there, for now. It’s up to you to use them. Find the plans that you qualify for and save your money. Be sure to maximize any match your employer may provide in a 401(k). That’s free money. Understand the tax implications (or hire a CPA), and accurately submit your taxes.
Then for all accounts, pay attention to withdrawal rules so you aren’t penalized. That would reverse all the tax savings you worked so hard for.
Please note: I am not a CPA or tax expert of any kind. Consult a real one for questions about your own personal tax questions. Many of the limits and parameters of these tax-friendly accounts change from year to year. I’ve done my best to provide current and accurate details and numbers. But not all relevant information is provided here and the numbers will likely adjust in the future.