Without Tax-Free Investing I’m Leaving A Lot On The Table

Ttax free and deferred investments

Investments (MP) Thanks to the Uncle Sam’s tax code, I have several ways to save money through investments that are tax-free and tax-deferred. And just like two-thirds of Americans, if you are unsure you’ve saved enough for your retirement years, investment vehicles offer a nice way to defer giving your hard-earned money to the IRS at least for a while. Remember, your goal is not to pay the least tax possible but to maximize the after-tax returns.

There are nine popular investment areas I’d focus on – Let’s take a look at the Pros and Cons of each.

Popular tax-free and deferred investment vehicles

1. Individual retirement accounts

Known popularly as IRAs, for more than 30 years, these accounts have provided people a means to save for retirement and save money on taxes. Anyone who works, either for themselves or an employer, can put aside a part of their income in a personal IRA or another retirement account. Through the years, the concept has been refined, with tax savings and earnings possibilities enhanced. Generally, people with wage income (instead of self-employment earnings) will choose to contribute to either a traditional IRA or a Roth IRA.

Traditional IRAs

Traditional individual retirement accounts, or traditional IRA, in short, is a type of investment account which enables money to grow tax-free until the account owner turns 59 1/2. Money can be put into these accounts for last tax year up until the April 15 tax-filing deadline.

Pros: Earnings are tax-deferred, meaning you won’t owe the IRS until you make withdrawals, which you’ll be able to start taking at age 59½. An employee age 50 or older (younger than 70½) can put in another $1,000 a year. Some people also might be able to deduct these contributions.

Cons: You’ll eventually owe taxes on at least some of the money in the account. You won’t be able to contribute once you reach age 70½. When you reach that age, you must start taking out a minimum amount based on an IRS distribution calculation.

2. Roth IRAs

The Roth IRA’s principal difference from most other tax advantaged retirement investing plans is that, instead of granting a tax break for money placed into the plan, the tax break is granted on the money withdrawn from the plan. Roth IRAs allow an annual contribution of up to $5,000 for 2012 ($6,000 if you’re age 50 or older), so long as you get paid at least as much as you contribute.

Pros: The earnings are tax-free. This appeals to account holders who open Roth IRA’s early and allow the money to grow for decades. You can contribute at any age. You can take money out on your timetable, not on the IRS’s age 70½ withdrawal schedule.

Cons: Contributions aren’t tax-deductible. There is an earnings limit which restricts higher-income taxpayers from contributing to or converting traditional IRA money to a Roth account.

3. 401(k) plans or workplace retirement savings

Most private sector employers offer participation in 401(k) plans for a good reason. They come with various tax breaks that aid in workers amassing handsome savings over time.  Since 2014, you could put away up to $17,500 of pretax earnings in a plan, and those who are 50 or above can save $23,000. Assets grow tax-deferred, meaning you don’t pay the IRS until you cash out of your 401(k), this allows capital gains and dividends to be reinvested, thereby maximizing growth. The best part about 401(k) plans?

Pros: Employee money goes into the account before payroll taxes are figured, meaning you’ll save a bit on withholding taxes.  Your employer matched contributions help to boost your retirement savings. Employers help contribute to them on behalf of employees. This year, the limit on joint contributions from employers, plus their workers is $52,000 per person or $57,500 for those 50 and older.

Cons: Contributions and earnings are tax-deferred, meaning you’ll owe the IRS when you take the money out at retirement. You must begin distributions by age 70 and one-half.  Not all companies match worker contributions and some that do match do so with company stock and not cash.

4. Roth 401(k) plans

Roth 401(k) plans combine the basics of 401(k)s. Essentially, workers put money into Roth 401(k)s after payroll taxes are withheld, meaning the account doesn’t offer an immediate tax benefit. However, when the money is withdrawn, it is Uncle Sam free. Whether your 401(k) is a regular or Roth account, ultimate responsibility for your workplace retirement savings rests entirely on you.

Pros: Distributions are tax-free. Contribution levels of regular 401(k)s, are much higher than they are for IRAs. Employer matching contributions increase your retirement savings.  Because there are no adjusted gross income caps, higher-income workers who can’t open a Roth IRA can contribute to a Roth 401(k). You can leave money in the account past age 70½.

Cons: Not yet as available as regular 401(k) plans. Because the money goes into this account after taxes are withheld, you receive no immediate tax break.

5. Medical spending accounts

They may be called flexible spending accounts, or FSAs, are IRS-approved, tax-exempt accounts that save you valuable tax dollars on eligible medical expenses. Every payday the amount of money that you specified is deducted from your gross pay before federal income, Social Security, and Medicare taxes are calculated. Employee monies go into the account before payroll taxes are figured, so your withholding taxes will be slightly less. FSA money pays for out-of-pocket medical expenses (co-pays, deductibles) you would have to pay anyway.

Pros: You can use your FSA money even before you’ve actually put money into the account. For example, let’s say you sign up to contribute $1,000 to your medical FSA, but have deposited only $100 when you are faced with a $300 out-of-pocket cost. You still can collect the $300 from your account. Also, you can use FSA money to pay for over-the-counter medications.

Cons: Companies limit the amount you can put into your medical FSA.  FSA money not used does not roll over into the next benefit year.  Note: The PEBB FSA limit remains at $2,500 for 2015. Find out which is Right for You.

6. Dependent care spending accounts

Similarly, Dependent care FSAs are arranged through your workplace. Participants authorize their employers to withhold a specified amount from their paychecks each pay period and deposit those funds in an account.  You don’t use FSA money to pay for expenses directly, you pay those costs out-of-pocket and then apply for reimbursement.  If you have extreme medical bills that you can deduct or want to claim the dependent care tax credit, talk to your tax adviser about how these accounts could affect these other tax considerations. As with a medical FSA, contributions are created pretax. In addition to paying for child care costs, the funds also can go toward expenses to care for a physically or mentally disabled adult dependent so that you can work.

7. Health savings accounts

In general, you can take advantage of the full tax-free and deferred benefits of an HSA by contributing the maximum allowed—within reason of your budget, of course. HSAs may have better tax benefits compared to IRAs or 401ks. Why? You never pay taxes on contributions, interest, or distributions, nor the maximum contribution in your HSA first. One exception might be if your employer matches 401k contributions—then, it’s best to put your money in the 401k up to the matched amount. If you have family healthcare, you can pay for your partner’s medical expenses with your HSA, even if your spouse doesn’t share the HSA. Individuals age 55 and older can make extra catch-up contributions to the HSA each year until they enroll in Medicare.

Pros: You get an immediate deduction on your Form 1040 for contributions to an HSA. And you don’t have to itemize to claim this deduction. Even if someone else, such as a relative, makes the contributions to your HSA, you still get the tax deduction. HSA earnings grow as long as HSA funds pay for eligible medical expenses, you owe no tax on the distribution. Any money in the account at year-end can be carried forward to the next year.

Cons: You have to pay a high deductible for medical care, meaning you’ll have to come up with the doctor and pharmacy payments and then be reimbursed from your HSA.

8. College savings plans

A 529 Plan is an education savings plan operated by a state or educational institution designed to help families set aside funds for future college costs. It is called 529 Plan after Section 529 of the Internal Revenue Code which created these types of savings plans in 1996. All 50 states and the District of Columbia sponsor at least one type of these plans.

Pros: All money grows federal and state income-tax free, withdrawals used for qualified higher education expenses are exempt from federal income tax. Lots of states exempt withdrawals from state income tax for qualified higher education expenses. The account holder retains control of the assets within the program regardless of beneficiary’s age. Many plans have very low monthly minimum contribution limits making them attractive to families regardless of income status. Some states have minimum limits as low as $15.

Cons: The plan’s money is not guaranteed by the associated state government and is not federally insured. If you use account money for ineligible expenses, you’ll owe federal taxes on the amount as well as an extra 10 percent penalty on earnings. Savings in a 529 plan could cut a student’s eligibility for other financial aid. Pay close attention to the plan’s fees, which could take a substantial cut of its earnings.

9. Savings bonds

This tax-free and deferred savings vehicle is often overlooked, but today’s savings bonds are not the bonds your grandparents. Enhancements to these federally backed instruments make them attractive to many looking for an easy, safe and, in some instances, quite competitive way to store away cash. The most popular savings bonds are Series EE, the fixed-rate variety, and Series I, which is indexed periodically to inflation.

Pros: The purchase price of a Series EE bond is just half its eventual maturity value. Both EE and I bonds come in eight denominations, ranging from $50 to $10,000. You can buy bonds directly from the U.S. Treasury at TreasuryDirect Bonds. Interest earned is exempt from state or local taxation. Federal taxes are deferred until you cash the bond, but if you redeem them to pay for higher-education expenses, you might be able to also avoid federal taxes on the earnings.

Cons: Unless the bonds are used for college costs, you’ll eventually owe the IRS for the accrued earnings. The Series I bonds don’t offer half-price purchase options,  it requires that you hold both types of bonds at least one year before you can redeem them. Remember if you redeem the bonds before five years both series will charge a three-month interest penalty.  You need to pay attention to when you cash in the bonds because the redemption timing affects the amount of interest you’ll get.

Don Briscoe
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Don Briscoe

Finance educator, advisor, and leading voice in the global financial literacy movement.Founder and editor of MoneyPacers.com.He lives and enjoys life with his family in New York.
Don Briscoe
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