Optimize Your Tax Liability While Saving for the Future
As you’re planning for your financial future, you’re likely making decisions about where to live, how much to save and what type of investments meet your needs. But have you considered the tax treatment of growth within — and withdrawals from — your various accounts?
A great way to optimize the investment return within your savings and brokerage account is to utilize tax-advantaged accounts. Tax-advantaged accounts can provide tax benefits for investors no matter their current investment time horizon and typically fall into one of three categories, which I will explain.
#1 – Tax-deferred accounts
Tax-deferred accounts provide an opportunity to make pre-tax contributions that lower your taxable income during the year in which the contributions are made. Assets held within the account grow tax-deferred for your retirement, which, thanks to the power of compounding interest, can provide a significant boost to your long-term savings goals.
It’s important to note that tax-deferred assets become taxable as ordinary income when they’re withdrawn from the account. In addition, if you take a withdrawal before reaching age 59 1/2, you may be subject to a 10% early withdrawal penalty in addition to your ordinary income tax liability.
Another consideration for tax-deferred accounts is required minimum distributions (RMDs). Per current IRS law, investors with assets in tax-deferred accounts are subject to RMDs, which means you must withdraw a portion of your assets each year once reaching age 72 (73 if you reach age 72 after December 31, 2022). As a result of the passage of the SECURE 2.0 act, the age at which RMDs must begin will be pushed to age 75 for investors born in 1960 or later.
Tax-deferred account types include:
- Traditional IRAs – Traditional IRAs are individual retirement accounts that allow you to make pre-tax contributions that grow tax-deferred for retirement.
- 401ks, 403bs and other qualified retirement plans –These are employer-sponsored plans that offer employees an opportunity to set aside pre-tax savings for retirement. Many employer-sponsored plans offer the added benefit of matching a percentage of employees’ contributions to the plan. For example, an employer may offer to match 50% on the first 6% employees contribute to the plan.
#2 – Tax-exempt accounts
Contributions to tax-exempt accounts are made with after-tax funds, which means you pay ordinary income taxes on the amount you contribute. The growth that occurs in these accounts, along with withdrawals from the account after age 59 1/2, are exempt from taxes if the account has been open for at least five tax years. Paying tax on some of your assets now can be a great benefit to investors who expect to fall into a higher tax bracket or expect the government to increase ordinary income taxes rates in the future. In 2026, unless Congress takes action to preserve the lower marginal income tax rates implemented as a result of the passage of the Tax Cuts and Jobs Act, tax rates will revert back to pre-2017 levels. Today, the top tax rate at the federal level is 37%. Prior to 2017, the top tax rate was 39.6%.
Unlike tax-deferred accounts, tax-exempt accounts aren’t subject to RMDs, which means these assets can remain in the tax-advantaged account longer and potentially experience more growth.
Tax-exempt account types include:
- Roth IRAs – Roth IRAs allow you to pay taxes on your contributions in the current year in exchange for tax-exempt growth and tax-exempt withdrawals in retirement (if the account has been open for at least five tax years).
- Roth 401ks, Roth 403bs and other after-tax retirement plans –Many employers offer their employees an opportunity to make after-tax contributions to an employer-sponsored retirement plan. Similar to Roth IRAs, these accounts allow you to pay taxes on your contributions now in exchange for tax-exempt withdrawals in retirement.
#3 – Accounts with tax-exempt withdrawals
Accounts with tax-exempt withdrawals are typically designed to help you save for a particular expense, such as healthcare or education costs. Withdrawals from these accounts are tax-exempt as long as the assets are used to pay for the intended qualifying expenses.
Account types include:
- Health savings accounts (HSAs) – HSAs offer three distinct tax benefits:
- Pre-tax contributions that lower your taxable income in the year they’re made
- Tax-exempt growth within the account
- Tax-exempt withdrawals when funds are used to pay for qualified medical expenses
- Flexible spending accounts (FSAs) – FSAs are sometimes offered by employers to help employees pay for out-of-pocket medical expenses using tax-exempt funds. Examples of qualified expenses include insurance copays and deductibles, medical devices, qualified prescription drugs and insulin.
However, there’s one big caveat to these accounts. Unlike HSAs that can exist perpetually, FSAs have a use-it-or-lose-it provision. That means if you have an account balance above a certain amount at the end of the year, you may be forced to forfeit those funds. Employers can offer one of two options for any remaining funds at year-end:
- A period of two and a half months to spend the remaining money
- The ability to carry over up to $640 to the next plan year
- 529 education savings plans– 529 plans provide a tax-advantaged way to save for a loved one’s education expenses. Although contributions to a 529 account aren’t tax-deductible at a federal level, many states offer income tax deductions on contributions to the state’s plan. If you happen to reside in one of the nine 529 tax parity states (Arizona, Arkansas, Kansas, Maine, Minnesota, Missouri, Montana, Ohio or Pennsylvania), you can make contributions to an out-of-state 529 plan and still qualify for state income tax deductions. Contributions grow tax-deferred within the account, and withdrawals are tax-exempt when used to pay for qualified education expenses, such as tuition, books, school supplies, and room and board.
Saving in accounts with different tax treatments gives you the flexibility to draw retirement income from different types of accounts in order to optimize your overall tax liability. Ultimately, this practice can help maximize your retirement income while reducing your tax bill.
Could you use some help investing in tax-advantaged accounts? Creative Planning is here for you. Our experienced teams take time to get to know you, your current financial situation, your goals for the future and any challenges you may face before offering well-informed, custom solutions to meet your needs. For more information, please schedule a call with a member of our team.
