Dear First Mates,
Tax season is upon us. But have no fear, your captain is here. Before we begin, be sure to check out these handy tax reference guides for 2020 and 2021, as well as key dates for 2021. You can expect a tax reference guide, just like these, each year from me. I can think of no better time than tax season to discuss some tax strategies to earn the trifecta of tax benefits: lower your taxes legally, save for future goals, and invest your money so it grows! In this newsletter, we will discuss different account types that serve as phenomenal tax shelters for retirement, education, health care, and even charity!
If you follow the rules, tax-preferred savings vehicles, like the ones discussed below, can provide up to three different tax benefits:
- Lowing your taxable income at the time of your contribution
- Growing your money in an investment that is tax-deferred; and
- Receiving distributions as income tax-free.
Health Savings Account: Health Savings Accounts (HSAs) are for individuals covered under high-deductible health plans (HDHPs) to save for qualified medical expenses. For 2020, an individual can contribute up to $3,550 (family coverage up to $7,100). For those 55 and older, there is an additional $1,000 per year. This additional permitted contribution is referred to as a “catch-up.” Contributions can be made by the tax-filing deadline, which is generally April 15th of the following year. The tax benefits offered by an HSA include items 1, 2, and 3 above.
Captain’s Log: For 2021, HSA contributions can be made until May 17, 2021 due to the recent tax-return extension.
Donor Advised Fund: The Donor-Advised Fund is a private fund created for the purpose of managing charitable donations on behalf of individuals, families, or organizations. A beneficial feature of this account is that an individual can receive the tax deduction in the current year, but donate to the charity in a future year. The deadline for making these contributions are year-end. Tax benefits received include items 1, 2, and 3 for individuals who are itemizing deductions.
Captain’s Log: Consider a strategy of bundling (“bunching”) your charitable giving which allows you to condense several years’ worth of giving into one year and gain the maximum tax benefits available.
529 Savings Plan: A 529 plan is a savings plan designed to help pay for education costs (K-12, post-secondary, and apprenticeship programs). For starters, anyone can open and fund a 529 savings plan – the student, parents, grandparents, friends, and even relatives! The contribution limits for 529 plans are generally high – ranging from $200,000 or more, depending on the state. The deadline for making these contributions are year-end. Tax benefits received include items 2 and 3, as well as a state tax deduction for contributions in certain states. Quite powerful, indeed!
Traditional IRA: A Traditional IRA (individual retirement account) allows individuals to contribute pre-tax dollars for retirement where investments grow tax-deferred until withdrawal during retirement. To check your eligibility, check out this handy flowchart as there are some hurdles with this vehicle. The contribution amount is $6,000 per year per person in 2020 ($7,000 for those age 50 or older). A Traditional IRA can be established at any time, however, contributions for a tax year must be made by the tax-filing deadline (generally April 15th of the following year). Tax benefits received include items 1 and 2.
401(k) Plan: This is a popular defined-contribution retirement plan offered by many employers to their employees. It is named after a section of the U.S. Internal Revenue Code. As of 2020, the basic limits on employee contributions are $19,500 per year ($26,000 for those age 50 or older). Employers may match their employee contributions. This match is essentially free money from the employer, making this vehicle very beneficial. It is advisable to contribute at least enough money to get the full employer match. Contributions to a 401(k) are generally due by the end of the calendar year. Tax benefits received include items 1 and 2. Please, see the “summary plan description” of your employer’s 401(k) plan to learn more.
Captain’s Log: There are many other retirement plan account types that function similarly to 401(k) plans including: 403(b), the 457(b), SEP IRA, Simple IRA, and solo 401(k) plans. Tax-sheltered annuities (a.k.a. 403b plans) are retirement plans that can only be used by public schools and tax-exempt organizations. A deferred compensation plan (a.k.a. 457b plan) is offered to state and local government employees as well as highly paid executives at certain nonprofits. The SEP IRA, Simple IRA, and Solo 401(k) plans are used by self-employed individuals.
Now some of you may rightfully wonder: “Wait, I get a deduction upfront with the Traditional IRA and 401(k), but then still pay taxes later. If I still have to pay later, what’s the point?”
The answer is twofold:
1) Many people will find themselves in a lower tax bracket in retirement because they are not working. So, if you are in a 32% tax bracket while working but a 12% bracket in retirement, you keep the 20% difference when taking retirement distributions at that lower rate.
2) Allowing your funds to grow tax-deferred is an extremely powerful strategy because it allows more cash to be invested in the present and grow into a larger sum in the future. You can see the difference this makes with this calculator. This topic alone deserves its own newsletter!
Roth IRA: This is a special individual retirement account established by the Taxpayer Relief Act of 1997 and named for Delaware Senator William Roth, its chief legislative sponsor. It allows qualified withdrawals on a tax-free basis, provided certain conditions are satisfied. The contribution amount is $6,000 per year per person in 2020 ($7,000 for those age 50 or older). Anyone can contribute the full amount to a Roth IRA as long as they make less than $124,000 (single filers). For married couples, the limit is $196,000. While a Roth IRA can be stablished at any time, contributions for a tax year must be made by the tax-filing deadline (generally April 15th of the following year). Tax-filing extensions do not apply. Tax benefits received include items 2 and 3.
Captain’s Log: For 2021, IRA & Roth IRA contributions can be made until May 17, 2021, due to the recent tax-return extension. The limit for IRA contributions (Roth & Traditional) cannot exceed $6,000, or $7,000 if you’re aged 50 or older. Tax-filing extensions do not apply.
Roth 401(k): These plans serve as a unique hybrid retirement savings vehicle that combine many of the best features of traditional 401(k) plans and Roth IRAs. This type of investment account is well-suited for people who think they will be in a higher tax bracket in retirement than they are now, because withdrawals are tax-free. Tax benefits received include items 2 and 3. Please see the “summary plan description” of your employer’s plan to learn more.
Defined-Benefit Plan (a.k.a. pension plan): These employer-sponsored retirement plans allow eligible employees to take their retirement benefit as a lifetime annuity (lifetime monthly payments) or as a lump-sum at an age defined by the plan’s rules. It is called a Defined-Benefit Plan since everyone knows the benefit formula ahead of time – typically based on the length of employment and salary history. For self-employed individuals, these plans help supercharge their retirement as a 401(k) complement. General tax benefits received include items 1 and 2, but can vary based on the plan.
Captain’s Log: While the rules vary depending on the plan, if you withdraw money from a retirement plan before age 59.5, you are usually subject to an early-withdrawal penalty of 10% as well as income taxes owed on the distribution. The nice thing about the Roth IRA is that whatever you put in can come out income tax-free and penalty-free. Nevertheless, be sure you can afford to leave money placed in retirement accounts alone for the long haul!
Taxable Accounts: Taxable accounts (e.g. bank and brokerage accounts) don’t have any tax benefits but do offer fewer restrictions than the tax-advantaged accounts mentioned above. Unlike an IRA or a 401(k), an individual can withdraw money at any time, for any reason, with no tax or penalty. The only tax advantage received here is if they hold the investment in the account for at least a year, then they will pay the more favorable long-term capital gains rate.
In conclusion, there are many tax savings vehicles worth funding for 2020 and 2021. Depending on your goals, one may be better than another. Which one should you contribute to for retirement? The general rule is to use traditional structures to lower taxes today and Roth structures to lower taxes in the future. Check out this handy flowchart to help aid your decision. In general, I prefer using different vehicles to diversify from a tax perspective as seen in the image below. Please, do not take action on any of these items without speaking to your CPA or accountant first and foremost! See you next month my friends!
David Warshaw, CFP®