Take advantage of every tax break your Uncle Sam affords. When it comes to investing for retirement, education, and even paying for healthcare expenses, there are a ton of tax breaks. Find the tax-advantaged accounts for which you’re eligible and then try and max them out before even thinking about investing in a regular taxable account.
Traditional vs Roth
Some of these accounts give you a choice as to what kind of tax break you receive: Pre-tax (traditional) or post-tax (Roth). If you need to, brush up on the differences and which is best for your unique situation—all traditional contributions, all Roth contributions, or a combination of the two—before choosing accounts (traditional vs Roth).
Not all tax-advantaged accounts are created equal. Some accounts only allow Roth or traditional contributions, others will accept both. Some are employer-controlled, while others are individual accounts separate from any employer. This can be confusing, which is why I’ve included lots of links so you can get the information you need.
The following accounts are listed from the most valuable on down, considering tax advantages and contribution limits. Keep in mind your unique financial situation may make a lower-ranked account more valuable to you. Also, don’t fret if you only qualify for the accounts near or at the bottom: They still have great value and will add to your advantage.
Health Savings Accounts
Although this won’t be number one on everyone’s list, it’s at the top because a Health Savings Account (HSA) has more tax advantages than any other tax-advantaged account. That means, when invested properly, you’ll enjoy the biggest after-tax return here.
The reason it’s not a great fit for everyone is because the only way you can open and contribute to an HSA is if you have a certain type of healthcare called a high deductible healthcare plan, whether through your employer or an individual plan. With these plans, your cost of care during the plan year is higher than with a lower deductible plan in exchange for lower premiums. A high deductible healthcare plan has high deductible plan minimum deductibles and high deductible plan out-of-pocket maximums that must be met, which change yearly.
The sweetener to these plans is your ability to contribute and invest in an HSA, per the HSA contribution limits. If you can afford it and it makes sense for you and your family’s healthcare situation, don’t use your HSA money to pay for your out-of-pocket healthcare expenses. Invest that money for the future instead.
This strategy has the potential to have the biggest bang for the buck given an HSA’s four tax advantages. All scenarios assume a qualified HSA withdrawal (this link takes you offsite to irs.gov/publications/p502).
– tax deduction on your contribution
– no tax on contribution upon withdrawal like with traditional contributions
– tax-free earnings on contributions
– no payroll tax deducted if contribution made through your employer
Make sure you keep those unreimbursed medical receipts. They act as tickets to tax-free withdrawals from you HSA anytime in the future. Once you reach age 65, you can use your HSA money for things other than healthcare expenses if you want to and avoid the stiff 20% IRS penalty for non-qualified withdrawals.
To contribute to a Roth IRA in any given year, you must be under the Roth IRA Income Limits. Otherwise, your contribution amount could be reduced or disallowed altogether if you make too much money. Unlike a traditional IRA, whether you have an employer-sponsored retirement plan is immaterial–the limits are the limits.
A Roth IRA only excepts Roth contributions. If you want to make traditional contributions, you’d have to open and fund a traditional IRA, or do so through your employer’s plan. There are Roth IRA contribution limits that applies to both your traditional and Roth IRA contributions combined.
Tax and Penalty Free Withdrawals
Besides enjoying tax-free earnings, your Roth IRA is one of the few accounts that allow tax and penalty-free withdrawals before the age of 59 1/2. A lot of people don’t know this, but you can withdraw your past years’ principal contributions at any time and for any reason. Earnings on those contributions, however, must remain in the account until age 59 1/2 to enjoy the same treatment.
Everybody Needs One
That’s why I recommend opening and funding a Roth IRA, even if you have a Roth option through your employer’s plan.
If you’re over the AGI limits for making a Roth contribution in any given year but you still want to make one, there’s a work-a-round. It’s called a backdoor Roth conversion. This seemingly underhanded maneuver has come under fire in the past, and it very well may be illegal come the end of 2021. I’ll keep you posted.
If you’re lucky, your employer offers a good 401(k)-type plan. These plans include 401(k)s, 403(b)s, 457s, and 401(a)s. I call these plans 401(k)-type plans because from an employee’s perspective, they work pretty much the same. The 401k contribution limits are over three times the amount you can contribute to an individual retirement account or IRA. Having access to a good 401(k)-type plan can be a real game changer if you’re serious about wealth building.
No Roth Income Limits
Almost all 401ks now offer a Roth contribution option, and there are no income limits like a Roth IRA has. Plus, unlike IRAs, you can put both traditional and Roth contributions into the same account. Don’t worry, the custodian of your account keeps track of earnings, so you’ll know whether your money is taxable or not when you’re ready to take it out.
If you’re really lucky, your employer not only offers a 401(k), but after-tax contributions (different from Roth contributions) and the ability to execute what has become known as a mega-backdoor Roth conversion.
Now you can potentially contribute almost 10 times the amount you can contribute to an IRA. This maneuver is currently still perfectly legal, but it continues to come under fire by Congress because of the tremendous advantages availed to those employees who can take advantage. In fact, pending legislation could make it illegal come the 1st of 2022.
It’s not a given it won’t be available in the future. This work-around has come under fire in the past and survived. I’ll let you know through my Best Money Newsletter about any future changes to the law.
“Dog” 401(k) Plans
I’m not sure how I got into the habit of calling really terrible 401(k) plans “dog” plans. I’ve always had a dog. I have one now (Rosie) and love her as I have all of them. My apologies to Rosie and your pooch too.
Unfortunately, there are 401(k)-type plans that don’t come with the advantages described above. Worse, many hire custodians that charge you high fees to invest in their funds, often to avert their own start-up fees. So shortsighted. Unfortunately, you’re stuck with it.
If you have one of these dog plans, you have my sympathies. Contribute up to any company match, then invest your hard-earned dollars in alternate tax-advantaged accounts.
If neither you nor your spouse are offered a retirement plan by your employer(s), there are no AGI limits on making an IRA contribution up to the traditional IRA contribution limits. These contribution limits cumulatively apply to Roth, traditional, and non-deductible after-tax contributions.
However, there are traditional IRA AGI schedules that determine your eligibility to make a deductible traditional IRA contribution if you or your spouse are covered by an employer retirement plan.
Other Tax-Advantaged Accounts
If you are self-employed, besides your IRA choices, you have a plethora of delectable tax-advantaged accounts to choose from that blow away the IRA contribution limits. This is true even if you are your only employee.
Directing Money to Tax-Advantaged Accounts
If you’re serious about wealth building, you’ve got to invest most if not all of your most important money into tax-advantaged accounts. These accounts guarantee you a higher after-tax rate of return when compared to investing in a regular taxable account because of the tax advantages.
It’s also important to find custodians who offer quality investments and low fees. A custodian is the financial company that offers these accounts, whether directly to you as an individual or through your employer.
Add an excellent investment plan, including risk management strategies, and you’ve assembled one of the most effective wealth-building weapons on the planet!