Saving for retirement or other big life moments is often viewed as an end in itself: Sock away a little bit each month, and you’ll achieve your financial goals. But many of these accounts can also play a role in lowering your tax burden here and now.
Take Erin Lowry, a self-employed personal finance expert who blogs at BrokeMillennial.com and whose book “Broke Millennial Takes on Investing” will be published in early April. Her transition from company employee with a 401(k) to self-employed worker included the challenge of setting up a new retirement plan.
“The advice out there is for the traditional employee, like, ‘Make sure you get the employer match,’” she recalls. “As a self-employed person, retirement is entirely on my shoulders.”
That includes navigating a complicated set of issues when it comes to retirement savings, such as deciding which type of account best fits her needs.
Lowry said she eventually picked a SEP-IRA, which has higher contribution limits than traditional or Roth IRAs. It also has the advantage of helping with tax planning because contributions are tax-deductible.
The SEP-IRA allows Lowry to contribute for the previous tax year until the tax-filing deadline of April 15, which gives her time to strategize with her accountant on last-minute contributions to lower her taxable income. “I’ll put in a little more right before I finalize my tax return for 2018,” she notes.
Tapping those types of tax strategies are crucial for financial planning, says Chantel Bonneau, a wealth management adviser at Northwestern Mutual. And more workers may be thinking about getting a better handle on their tax burdens after the massive tax overhaul that went into effect last year, she adds.
That being said, she advises people to focus on their financial targets first and foremost.
“We all want tax benefits, but make sure you are doing things that will get you closer to your goal,” she says. In other words, “Don’t buy a house for the tax benefit – buy it because you want to own a house.”
Below are five key accounts that help lower tax burdens either now or during a life transition, financial experts say.
Offered by employers, 401(k) plans allow workers to set aside retirement funds on a tax-deferred basis. Those contributions will lower your taxable income in the year they are made, reducing your current tax bill. However, you’ll pay income tax on your withdrawals once you hit retirement and start tapping the account.
Several other plans offer similar tax-deferred savings, including the traditional IRA and the SEP-IRA used by Lowry, with the latter geared toward self-employed workers or small-business owners.
The Roth IRA, however, offers a different type of tax advantage: You pay income tax on contributions in the year you make them but withdraw the funds tax-free in retirement. Roth IRAs can offer savings for workers who believe they’ll be in a higher tax bracket when they retire, notes Bonneau.
The tax advantage of Roth IRAs attracted Susanmarie Harrington, a professor at University of Vermont in Burlington. She started setting up IRAs when she began working but switched to Roth IRAs because, she says, “it seemed more tax advantageous.”
Flexible spending accounts
There are two types of tax-advantaged accounts geared toward medical expenses, flexible spending accounts and health savings accounts, but they have significant differences.
Flexible savings accounts (FSA) are limited to $2,700 per contributor in 2019, meaning that is the maximum tax-exempt amount a worker can set aside. Those funds can then be used to pay for health care expenses like co-pays or medication. But there’s one big drawback: These accounts are “use it or lose it,” which means you lose the amount you’ve set aside if you fail to file for reimbursement before the FSA claim deadline, typically in March of the following year.
Heath savings accounts
HSAs are “triple tax-advantaged” plans for people who have high-deductible health care plans, says Shobin Uralil, the COO and co-founder of Lively, an HSA provider. Funds are contributed on a pre-tax basis, and if they are used to pay for medical expenses, they’re also not subject to taxes. Lastly, some contributions may also be exempt from Social Security and Medicare taxes, Uralil added.
Unlike FSAs, the funds “stay with you,” Uralil adds. “Even though the account may be provided by your employer, you as the account holder are the one who owns the funds, and you are the one who gets the tax benefit. When you leave, the funds stay with you.”
College is another expensive life event where tax breaks can provide welcome relief. 529 plans are typically more flexible than consumers realize, says Ksenia Yudina, CEO of U-Nest, an app that provides 529 investing, and a former financial adviser.
Parents don’t need to open a plan in the state where they live, and grandparents and other relatives and friends can also invest in a 529 plan, she adds. And the plans offer significant tax breaks, she notes.
While you put in after-tax dollars, those contributions grow tax-free, and withdrawals are not taxed, either.
“Some people don’t realize that 529 plans have those major tax benefits,” she says.
Contributions can be invested in a number of mutual funds, index funds or other investments. On top of the investment gains, “the tax benefits compound,” Yudina says. “So over the long-term, it makes a huge, huge difference.”