There are some personal finance topics that get a lot of focus. Budgeting, tracking your spending, and paying down debt are a few of them.
And then there is tax hacking.
Let me be clear: I am not advocating doing anything illegal. Tax hacking is simply leveraging the tax code to your advantage.
Tax hacking can be as simple as saving your receipts from your nonprofit donations so that you can deduct it come tax time. Or keeping records on your gambling losses to offset any wins.
The point is this: far too many, especially in the millennial demographic, are not focusing on saving money through taxes.
I’ve personally become more and more interested in tax savings the past few years. What I’ve found is that tax hacking doesn’t have to be complicated.
The best way to start saving money on taxes is through tax-advantaged accounts. Even simply understanding what the accounts are and how they function will put you well on your way to saving significant amounts of money through taxes.
Below is the ultimate list of tax-advantaged accounts to help you get started on saving thousands on your taxes.
401(k), 403(b), and solo 401(k) Retirement Accounts
We’ll kick off this list with the most widely known account: the 401(k). When talking about 401(k) plans I also like to acknowledge 403(b) plans, which are very similar and offered at some nonprofits. Additionally there are solo 401(k) plans designed specifically for employers with no full-time employees other than the business owner or owners and their spouses.
When you deposit money into a 401k account you essentially shield your income from taxes until you withdraw your income in retirement. Many employers offer 401k matching up to a certain percentage, and this benefit has become a staple of many employee benefit plans.
The IRS sets employee contribution limits for 401(k)s, and the limit for 2017 is set at $18,000. Those 50 and older can contribute up to an additional $6,000.
You shielded your money from taxes, so now what? When can you get your money out of your 401(k)?
Once you reach the age of 59 1/2 you can start withdrawing from a 401(k) without an early withdrawal penalty. For tax purposes your withdrawals will be treated as ordinary income. If you withdraw prior to the age of 59 1/2 you will have to pay income taxes on the withdrawal and pay a 10% early withdrawal fee.
The one exception is if you retire at age 55 or later. If that’s the case, most 401(k) plans allow for penalty-free withdrawals.
Roth & Traditional IRAs
Roth and Traditional IRAs are the second-most popular retirement accounts. They are very similar to each other with the exception that deposits to Roth IRAs are made with after-tax dollars and deposits to Traditional IRAs are tax deductible.
The most an individual can contribute to an IRA or IRAs in a given fiscal year is $5,500 for those age 49 and under, and $6,500 for those who are 50 and older, for 2017. There are income limits for contributing to IRAs. Fidelity has a good breakdown of what these limits are for Roth and Traditional IRAs, respectively.
The debate will rage on forever as to whether it’s better to contribute to a Traditional or Roth IRA. Traditional IRAs give you the tax savings now, but Roth IRAs allow your investments to grow tax-free. Both have their benefits.
Similar to 401(k) accounts, Traditional IRA accounts are available penalty free once you are 59 1/2 or older and are treated as regular income for tax purposes. If you withdraw prior to 59 1/2 you will be hit with a 10% early withdrawal fee on top of the regular income tax owed on the withdrawal.
Roth IRAs are treated slightly different, especially from an early withdrawal perspective. You can make early withdrawals prior to age 59 1/2, but only up to what was deposited. This makes sense as your deposits were already taxed. But you’ll want to wait to withdraw until you are 59 1/2 or older to avoid having to pay taxes on any of the gains.
IRAs are very easy to open. Many financial institutions offer IRAs including USAA and TD Ameritrade.
Self-Directed IRAs
Self-Directed IRAs are a type of IRA that are not widely used. Self-Directed IRAs give the account holder much more latitude as far as what investments they hold.
The wider variety of investments is what attracts people to Self-Directed IRAs. Residential and commercial real estate in particular are investments that people are drawn to.
Imagine, for example, rolling a $100k Roth IRA over to a Self-Directed IRA. You could buy a house as an investment and none of the rental income or appreciation on the home would be taxable. Would you rather purchase a rental unit with your own money and pay taxes on the rental income and appreciation when you sell or hold that same rental unit within a Self-Directed IRA where none of it is taxable as long as you wait until retirement to withdraw funds?
I oversimplified things in the previous example, but you get the point. Self-Directed IRAs can be a powerful tool from a tax hacking perspective. There are a lot of rules that come with Self-Directed IRAs, so be sure to do your research before deciding to open one and/or converting your Traditional or Roth IRA into one.
Health Savings Account (HSA)
Oh how I love HSAs. HSAs are my favorite tax-advantaged account, and for good reason: they are Traditional IRAs on steroids!
HSAs have a “triple tax advantage” that includes:
- Deposit income tax free
- Withdraw funds tax free when used for a qualified medical expense
- Invest funds after reaching a certain balance (i.e. $1k or $2k) – investment gains are not taxed when withdrawn for qualified medical expenses
The best part? If you reach retirement age you can withdraw funds similar to a Traditional IRA. And that’s the beauty of it. HSAs include all the benefits of Traditional IRAs but have the extra perk of allowing you to withdraw funds for qualified medical costs tax free. There is no “use it or lose it” clause with HSAs so even if you switch employers or insurance plans you will retain your HSA.
The unfortunate thing about HSAs is that most people don’t contribute to them until they need the money. In reality the best time to put money in it is before you need it. Regardless of whether you have a lot of medical bills or hardly ever have medical bills, there is a huge incentive to max out your HSA. Worst case scenario (and this is not a bad scenario) you have no medical costs and you withdraw funds in retirement similar to a Traditional IRA.
There is one negative to HSAs when compared to Traditional IRAs. You need to be 65 or older to withdraw funds for non-qualified medical expenses. This is obviously higher than the 59 1/2 age limit for Traditional IRAs. If you use funds for non-qualified medical expenses prior to 65 you are not only subject to income tax, but you are also hit with a 20% fine.
The maximum contribution to an HSA for an individual in 2017 is $3,400. For a family the contribution limit is $6,750. Those 55 and older can contribute an additional $1,000.
You need to have a High Deductible Health Plan (HDHP) to contribute to an HSA and reap it’s benefits, but it’s becoming increasingly difficult to find plans offered that aren’t HDHPs.
While most insurance plans will already have an HSA provider for you to use, you can also set up an account at Alliant Credit Union. As HSAs gain popularity I expect to see more and more financial institutions looking to service HSAs, and increased competition is always good for consumers.
Why You Should Contribute to an HSA When You Are Young
529 College Savings Plans
A 529 plan is operated by a state or educational institution that offers tax advantages when used for college savings. There are a large number of 529 plans as each state typically offers their own plan.
It’s important to be clear what the tax advantages for 529 plans are. Contributions are not deductible, but earnings are not subject to federal tax (and typically not state tax either) when used for qualified education expenses of the designated beneficiary. These expenses include things like tuition, fees, books, and room & board.
Per Federal law, a state program must not accept contributions in excess of the anticipated cost of a beneficiary’s qualified education expenses. Many states have used the most expensive school as a benchmark, as well as potential graduate school costs. $300k+ is not an uncommon threshold.
There is no annual limit on contributions as long as the amount contributed in total doesn’t go above the threshold set by the plan. Meaning, you could deposit a huge lump sum right away, or you could give contributions over time. Of course one argument for big up-front deposits is that the sooner you deposit the more time there will be for earnings to build.
While not as advantageous as some of the other tax-advantaged accounts we covered, 529 plans serve their purpose and do ultimately save the depositor on potential taxes.
Want to learn more about how to save money on taxes? Here’s some related articles:
6 Tax Advantage Savings for Millennials
5 Ways to Start Preparing For Tax Season Now
Why You Should Donate Even While on a Tight Budget
How to Pay Taxes for Side Hustles and Extra Income
Do you leverage tax-advantaged accounts to save money on taxes? Why or why not? Which accounts do you use?
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Solid list DC. We do all of them – Solo 401(k), Roth, HSA and 529 Plans for our kiddos. We max out the first three each year and make a significant dent in the latter. It’s a no-brainer, in my opinion, to take advantage of as much opportunity is available in this arena….legally of course. :)
Haha yes, legally of course. Great to hear that you are getting so much benefit out of these tax-advantaged accounts!
Great, informative list, David. We use all of these except the Roth & Self-directed IRA. Thanks for covering the latter–that was the one I didn’t know much about.
Thanks Kalie! The Self-directed IRA is less known, but can be an interesting and lucrative option down the road for those who want to invest in something out of the ordinary like real estate. It’s definitely intriguing!
Nice, comprehensive list! We take advantage of the 401k, IRA, HSA and have a 529 as well. We max out all of them except for the 529, so we reap the tax benefits each year.
That’s great that you max them all out! Lots of tax savings for you and your family.
This is quite an extensive list of all the tax hacks in one place.
In the IRA battle, my personal preference is the Roth for the simplicity factor because I know I won’t have to factor taxes in the withdrawals. Although, I will say they probably get more hype than they deserve.
As a self-employed person, pre-tax 401ks or IRAs are great too. As it’s an evergreen deduction for the short-term which can also be really valuable.
There is definitely something to be said about the simplicity of a Roth IRA. I also really like some of the opportunities for unique income streams that you can create with a Self-Directed Roth IRA.
Really interestin gand helpful post thanks for sharing!
Glad you enjoyed it!
Maybe I’m a finance nerd but I kinda enjoy learning about taxes. Well it can be pretty dry and boring but I’m all for saving on taxes. I take advantage of almost of the accounts you mentioned. No HSA because my employer doesn’t have a good high deductible plan. I have a self-directed IRA where I hold this crowdfunded real estate investment. I’ve considered using it to buy a house but it seems more complicated with the rules against self-dealing. Also, rental properties are pretty tax efficient as it is…the profits can often be deducted with expenses and depreciation. Capital gains can be avoided it’s owner occupied (up to $500,000 for a couple) and if not owner occupied there’s the 1031 exchange where you buy a like property.
Nice comprehensive list. Many people try to get “creative” with their deductions and income reporting to save some money on taxes. But the most bang for your buck (literally) will come from contributing to tax advantaged accounts.