Kevin Oleszewski, CFP®, MST, EA, Senior Wealth Planner
As you’re setting your new year’s goals, one that should top everyone’s list is increasing your savings. After all, we’ve recently seen inflation at work, reminding us that even everyday essentials can bust budgets if we’re not adequately prepared for the jolt.
While everyone has different financial goals and objectives, one smart strategy can be to reap the benefits of tax-advantaged accounts to help mitigate your tax burden, whether for today or down the road. Here’s what you need to know.
What Are Tax-Advantaged Accounts?
Let’s start with the basics. There are two types of tax-advantaged accounts:
- Tax-deferred accounts are those you fund with pre-tax income; eventually, you will pay tax when you take the money out, at whatever your income tax rate is at that time
- Tax-exempt accounts are funded with after-tax money, which means you won’t have to pay income tax on the gains that accrue when you withdraw the money
There are a number of strategies to deploy when deciding which accounts are right for you so it’s wise to seek counsel from a financial advisor and tax professional. But here are some common tax-advantaged financial vehicles and tips on using them to their greatest benefit.
401(k) or 403(b) accounts
The majority of workplaces offer these employer-sponsored accounts, called a 401(k) at a private, non-profit company and a 403(b) at a nonprofit or government agency. Typically, the account contribution will come directly from your paycheck, which makes them a convenient way to save.
Many companies even offer a match, usually a percentage of your contribution, which means you’re making money even before realizing any market return. That’s why I recommend saving at least up to the “match” amount, even if you decide to focus the rest of your savings on different vehicles. While there are limits to how much you can contribute, the IRS has bumped them up for 2023.
Contributions to a traditional IRA may be tax-deductible in the year they were made, depending on your income and whether your employer offers an account like a 401(k). They will then be taxed at your marginal tax rate when you make withdrawals. IRAs are appealing because of the wide number of investment options and can be a good add-on to other savings strategies.
These plans are a popular place to build college savings that will grow tax-deferred as long as the funds are used for qualified distributions for approved educational expenses. With some plans you may also qualify for a state tax deduction. However, only contribute to a 529 plan if you’re also simultaneously saving for retirement — after all, you can borrow for school but not for retirement.
One great way to fund 529 plans is to ask relatives to contribute. For affluent grandparents, in particular, it can be a good way to draw down their estate as they can put in up to $17,000 per year tax-free as part of the gift tax exemption. They can even contribute five years at once in a lump sum and spread it over five years for tax purposes.
Flexible Spending Accounts (FSAs)
Many employers offer FSAs, which allow you to contribute pre-tax money that can then be used for out-of-pocket healthcare costs your insurance doesn’t cover. Be aware that most plans, however, have a stipulation that you use it by the end of the year or lose it, so you don’t want to overfund the account. But if you know your child will be getting orthodontic treatment or you have planned for a procedure, it can be a good way to cover those expenses at a tax savings.
While life insurance isn’t an investment choice that suits everyone’s needs, it’s another option to consider. Universal, variable and whole life policies build cash value while also providing for your loved ones in the event of a tragedy. The death benefit is typically tax free and the value of your account grows tax free.
With a Roth IRA, you contribute after-tax dollars and then won’t have to pay any taxes when you eventually withdraw that money. These accounts are particularly attractive if you think you might be in a higher tax bracket when you retire. Of course, none of us has a crystal ball to know how tax rates might eventually fluctuate, but we do know they are currently historically low so this may be a chance to lock in tax savings before laws change. We often suggest people fill up these tax-exempt assets first for that reason.
However, there are income limits to a Roth IRA so not everyone qualifies. There is a workaround: You can convert funds from your traditional IRA to a Roth IRA so you’ll pay the tax now. That can be a wise strategy if you are in a lower tax bracket right now and want to eventually tap these funds tax-free and even pass on wealth to your heirs without saddling them with a tax bill. Now might be the time if your income has dropped significantly or your business has a loss for the year, but a financial advisor can help you make an informed decision.
If your employer offers a Roth 401(k), which some do in addition to a 401(k), it can be a great way to save for retirement in a way that may be beneficial when it’s time to take your withdrawals. There are no income limits on a Roth 401(k) so it can be a good complement to a traditional retirement savings plan.
Health Savings Account (HSA)
HSAs are one of my favorite ways to manage your taxes because they offer three types of tax breaks—a tax deduction when you contribute, tax-free growth and tax-free distribution. Not everyone can take advantage of them, though; HSAs are only offered as a supplement to a high-deductible health plan (HDHP).
HSA money is used for qualified medical expenses the health plan doesn’t cover. Unlike a FSA, it doesn’t have to be used on a certain timeframe, and you can keep it even if you change jobs. I find that people routinely overlook the power of these accounts and the tax benefits you’ll enjoy in retirement. Even if you have expenses, you could use it for, let your money continue to grow if you can cash flow those smaller needs, like glasses or a routine doctor’s visit, and your HSA essentially becomes another Roth IRA-type plan where you won’t owe taxes as you draw it down. There’s another benefit many people are unaware of. If you decide to pay for medical expenses out of pocket today, and later wish you had used your HSA funds, you can reimburse yourself for those expenses at any point in time if you keep your receipts. Just be diligent about record keeping.
Be Tax Smart in 2023
This bevy of investing options might seem overwhelming, and it can be easy to become overly preoccupied with exactly where you want to invest your money. Yet there’s one overarching principle you should remember: The best strategy is to put as much money as you can into an account of some type, ideally after talking with an advisor who can help align your goals to an investment vehicle. But generally speaking, investing your money in any sort of vetted account is preferable to doing nothing at all.
All of these types of accounts serve a purpose. The name of the game in building wealth is keeping that long-term perspective and aiming to achieve the lowest tax payment possible. Want to learn more? A Carson advisor can help.
Converting from a traditional IRA to a Roth IRA is a taxable event.
For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisor Networks LLC nor any of its representatives may give legal or tax advice.
Kevin Oleszewski is not affiliated or registered with Cetera Advisor Networks LLC. Any information provided by Kevin Oleszewski is in no way related to Cetera Advisor Networks LLC or its registered representatives.