A 2019 report by the Tax Foundation found that the average U.S. wage earner pays 29.6% of their income in taxes, amounting to $17,597 per year. That does not include local or state income taxes, sales taxes, property taxes, excise taxes, inheritance taxes, sin taxes, tolls, fees, and the many other ways that governments skim money from you.
I don’t know about you, but I could use an extra $17,597 per year.
Luckily, it turns out that taxes aren’t quite as inescapable as death after all. Savvy taxpayers can deeply slash their tax bill through a range of tax-sheltered accounts and other tax exemptions.
But the world of tax-advantaged accounts gets complicated quickly. Before committing thousands of dollars to any of the accounts below, check with your accountant to make sure you qualify for the deduction or deferral.
Workers have many options at their disposal for tax-sheltered retirement accounts. So many, in fact, that some workers get overwhelmed and give up on opening one of these accounts and contributing to it. A little clarity can help.
Broadly speaking, there are two types of retirement accounts: employer-sponsored accounts and individual retirement accounts (IRAs). An individual retirement account is one that you entirely own and manage by yourself. By contrast, although you own the funds in an employer-sponsored account, the employer operates the account on behalf of its employees who are enrolled — when you leave that employer, you typically liquidate the funds and roll it over to an IRA to manage yourself.
You open an IRA through a stock broker like M1 Finance or Stash Invest, just like a normal, taxable brokerage account. You keep complete control over it, you own it, and you can invest in any asset available from your broker.
This makes it far more flexible than employer-sponsored accounts, which come with limited investment options.
Unfortunately, traditional and Roth IRAs come with far lower contribution limits than employer-sponsored retirement plans. In 2020, workers under age 50 can contribute up to $6,000 annually to their IRA, while those age 50 and over can contribute $7,000.
Why so low? Because the federal government wants your money, of course! Which raises the primary tax benefit of traditional IRAs: you can deduct contributions from your taxable income. If you earn $50,000 and contribute $6,000 to your IRA, you pay income taxes on $44,000 rather than the full $50,000.
The IRS only allows deductions within certain income limits though. While taxpayers can contribute to their IRA at any income level, their ability to deduct the contribution on their tax return phases out above certain income limits. Single filers can only deduct the full contribution if they earn less than $65,000 in modified adjusted gross income (MAGI); above that, the ability to deduct contributions begins to phase out until it disappears entirely at $75,000. For married couples, the ability to deduct contributions phases out between $104,000 and $124,000.
With traditional IRAs, you do still have to pay taxes on withdrawals in retirement. You get a tax break today, but the money doesn’t grow tax-free, and you pay income taxes when you collect the money in retirement. You are required to begin taking income from the account starting no later than age 72, in the form of required minimum distributions (RMDs), so that Uncle Sam ensures he gets his cut of your money.
Roth IRAs feature the same contribution limit as traditional IRAs. In any given year, you can contribute to either or both, but the combined contributions must stay under the limit. For example, in 2020, a 30-year-old could invest $2,000 in their traditional IRA and $4,000 in their Roth IRA, reaching the combined contribution limit of $6,000.
Like traditional IRAs, you own and manage your Roth IRA through your broker.
But there are three key differences between Roth IRAs and traditional IRAs. The first is the tax benefit: instead of getting a tax break this year in the form of a deduction, you get the tax break when you go to withdraw the money from your Roth IRA in retirement. You still pay taxes now on the money you contribute — meaning you don’t deduct your Roth IRA contributions from your income today — but the money in this account grows tax-free, and you don’t pay any income taxes on withdrawals later in life.
Which is great, because your taxes may well go up in retirement. You will (hopefully) be wealthier by that point, and the prospect of higher federal and state tax rates in the future is very real.
Another difference between traditional and Roth IRAs is the income limit to contribute. Roth IRAs allow higher earners to contribute; single taxpayers can make the full contribution if they earn a MAGI up to $124,000, after which the ability to contribute phases out until disappearing at $139,000 in 2020. Married couples filing jointly start losing the ability to contribute at a MAGI of $196,000, and lose it entirely above $206,000.
Finally, account holders don’t have to take RMDs from Roth IRAs starting at age 72, like they do with Traditional IRAs. Since you’ve already paid the taxes on the contributions, Uncle Sam doesn’t force you to pull out money to trigger the income taxes.
The Simplified Employee Pension IRA, better known as a SEP IRA or self-employed IRA, works like a traditional IRA, but with much higher contribution limits.
Self-employed workers such as freelancers and small-business owners can contribute up to 25% of their self-employed income in 2020, capped at a maximum contribution of $57,000. Like other IRAs, you open and manage a SEP IRA through your broker.
The SEP IRA works like a traditional IRA, with deductible contributions and taxable withdrawals, and doesn’t offer a Roth option. But you can theoretically contribute money to both a SEP IRA and a Roth IRA if you meet the criteria for each.
You must meet all the following requirements to contribute to a SEP IRA:
- Be at least 21 years old
- Earn self-employment income as a sole proprietor such as a freelancer, or as a business owner
- Earn at least $600 in self-employment income during the tax year
- You must also include and set up a SEP IRA account for any employees who have worked for your business for at least three of the past five years.
As with traditional IRAs, SEP IRA holders must start taking required minimum distributions at age 72 to feed the tax machine. But SEP IRAs offer a simple way for the self-employed — with their extra challenges like retirement planning, self-employment taxes, and no employer benefits — to slash their tax burden and plan for their future.
These accounts were designed as a, yes, simpler alternative to 401(k)s for small businesses. They come with fewer administrative headaches and lower management costs, intended to incentivize small-business owners to provide retirement accounts as a benefit for their workers.
Employees under age 50 can contribute up to $13,500 in 2020, while those age 50 and above can contribute $16,500 annually. If your employer offers a SIMPLE IRA, you can contribute to both it and your own traditional or Roth IRA, assuming you qualify to do so.
Unfortunately, there is no Roth option for SIMPLE IRAs. Taxpayers looking to minimize taxes in retirement should contribute to their own Roth IRA in addition to their workplace SIMPLE IRA.
Note that employers who offer a SIMPLE IRA must offer one of the following to contribute to their employees’ accounts:
- Nonelective 2% Contribution. The employer adds an extra 2% of the employee’s wages to the account regardless of whether the employee contributes.
- Elective Matching Contribution, Up to 3%. The employer matches the employee’s contribution, up to at least 3% of their wages.
If you’re an employer considering opening a SIMPLE IRA for your workers, see the full IRS rules for more details.
Named after the subsection of the U.S. tax code that describes it, 401(k) accounts are employer-sponsored retirement plans designed to help workers save money with greater tax advantages than the standard IRA.
In tax year 2020, employees under age 50 can contribute up to $19,500. Those age 50 and older can contribute an additional catch-up contribution, for a total limit of $26,000.
Wondering why the government allows such a higher contribution limit for employer-sponsored retirement accounts compared to IRAs? It comes down to incentive structure: if the limit for 401(k) plans wasn’t dramatically higher, they wouldn’t appeal to employees, so employers wouldn’t bother with them. They’re expensive for the employer, who has to hire a 401(k) plan administrator to handle the legal compliance and manage the investments. And they’re less convenient for the employee, who doesn’t own the account itself, and who can only choose among the limited investment options provided by the plan administrator.
Fortunately, employees can contribute to both a 401(k) and a traditional and/or Roth IRA. Assuming they meet the criteria for each, of course.
Some employers offer matching contributions. If the employee contributes, the employer matches those contributions, up to a certain ceiling determined by the employer. In 2020, the combined total of employee and employer contributions is capped at $57,000 ($63,500 for taxpayers age 50 and older).
Employees must start taking required minimum distribution at age 72, as with traditional IRAs. However, employees can opt for a Roth option for their 401(k) contributions — called a Roth 401(k) — to pay taxes now and let their investments grow tax-free.
Self-employed workers can, if they so choose, open a solo 401(k) just for themselves.
In doing so, you can take advantage of both the employer- and employee-side contributions allowed under a 401(k). That means up to $19,500 on the employee side ($26,000 if you’re over age 49), and up to 25% of your income on the employer side, for a total of $57,000 in 2020 ($63,500 if you’re 50 or older).
Solo 401(k)s offer an alternative to the SEP IRA, with similar contribution limits. There are a few key differences you should understand before you decide between them, however.
First, SEP IRAs don’t allow a Roth option, while solo 401(k)s do.
With a solo 401(k), you contribute on both the employer and the employee side. But with a SEP IRA, you contribute as the employer only, subject to the 25% cap. Taxpayers with a solo 401(k) can contribute up to the full $19,500/$26,000 cap on the employee side, even if that means contributing more than 25% of their self-employment income.
If small-business owners hire even one employee (other than their spouse), they are no longer eligible for a solo 401(k), and have to create a standard 401(k) plan that covers employees too. In contrast, small-business owners with a SEP IRA can leave their SEP IRA in place and hire employees, but must contribute the same percentage to their employees as they contribute to their own SEP IRA. See the IRS rules on SEP IRA contributions for more details.
Solo 401(k) accounts require costly administration and limited investment options, unlike a SEP IRA.
Finally, Solo 401(k) accounts allow older adults to make the extra catch-up contribution; SEP IRAs do not.
Nonprofits, schools, and other tax-exempt organizations can implement a 403(b) rather than a 401(k) account.
These accounts work almost identically to 401(k)s, with the exact same contribution limits and rules. Like 401(k)s, 403(b)s allow both traditional and Roth options. When workers leave the organization, they roll over their funds to their IRA, just like a 401(k).
The difference between 401(k)s and 403(b)s lies in the simpler administration rules, making 403(b)s cheaper and easier for the employer to manage. But for workers, 403(b)s work just like 401(k)s.
Thrift Savings Plans
Federal employees, including military service members, can take advantage of the government’s Thrift Savings Plan (TSP).
It works similarly to a 401(k), with the same contribution limits. Like 401(k)s, account holders may start withdrawing funds as early as age 59 ½, and must start taking required minimum distributions at age 72 — except for Roth TSP accounts, which are an option, and don’t require RMDs.
Thrift Savings Plans come with generous employer matching contributions. Eligible government employees get a 1% contribution from Uncle Sam, no participation or contribution of their own required. For employees who contribute up to 3% of their paycheck to their TSP, the government matches them dollar for dollar. When employees contribute between 3% and 5% of their paycheck, the government matches $0.50 on the dollar, up to an additional 1% of their paycheck.
That comes to a maximum employer match of 5%.
Access to the TSP and employer matching help make military retirement benefits even more attractive, and combine with the military’s pension system.
Pro tip: If you’re investing in any of these types of retirement accounts, make sure you sign up for a free portfolio analysis from Blooom. They’ll analyze your accounts to make sure you have the proper diversification and that your asset allocation matches your risk tolerance. They’ll also look to see if you’re paying more than you should in fees. Sign up for a Blooom account.
While retirement accounts get most of the attention as tax-sheltered investment vehicles, you can also save on taxes by investing for your children’s education.
Coverdell Education Savings Accounts, or ESAs, work like Roth IRAs for education costs. You pay taxes on the contributions, but they grow tax-free, and you don’t pay taxes on withdrawals when used for qualified education expenses like tuition, room and board, and textbooks.
Like Roth IRAs, you open ESAs through your investment broker, and can invest in any securities you like. The rules are also set on the federal level, unlike 529 plans, making ESAs simpler and more consistent for anyone in the U.S.
There are two major limitations on ESAs. First, you can only contribute up to $2,000 per year in 2020 — hardly an impressive sum, compared to the soaring cost of a college education. Second, the beneficiary must use the money before turning 30, or they will face tax penalties.
In a final similarity to Roth IRAs, ESAs do come with income limitations. The ability to contribute starts phasing out at a MAGI of $95,000 for single taxpayers, and phases out entirely at $110,000. The income limit is double for married couples filing jointly, phasing out between a combined MAGI of $190,000 and $220,000.
Unlike ESAs, 529 plans are operated on the state level. That means every state offers different plans, with different rules.
These accounts come in two overall varieties: contributory investment accounts, which are similar to ESAs, and prepaid tuition plans.
Contributory Investment Plans
With contributory investment 529 plans, you contribute money just like with an ESA. You pay taxes on the contributions, but they grow tax-free, and you don’t owe federal income taxes on withdrawals.
Rather than placing annual contribution limits, the federal government leaves it to each state to set a lifetime total contribution limit for each beneficiary. The guidelines say that the contribution limit should be equivalent to five years of “qualified education costs,” and each state sets these individually. These start around $235,000 in states like Georgia and Mississippi and go up to $529,000 in California.
Some states also allow participants to deduct contributions from their state tax returns; others don’t.
On the downside, you don’t get much choice in investments. These accounts are operated by each individual state; when they give you any choice in your investments at all, the options aren’t diverse.
Prepaid tuition plans work differently. You pay a set amount of money while your child is still young to prepay their tuition years in advance. In doing so, you lock in a lower, fixed price for your child’s education within a particular state’s public university system. But these plans come with their own downsides and risks.
First, you lose out on the potential returns you could have earned on that money (opportunity cost). Second, your child may not attend college in that state’s university system — or at all for that matter. In that case, the state generally refunds your money, but again, you miss out on the investment earnings you could have made on it. Also beware that many states include plenty of fine print and loopholes with few or no guarantees for you the customer — read your states rules on prepaid tuition carefully.
Health Savings Accounts (HSAs)
The best tax advantages of any account actually come from a surprising quarter: health savings accounts or HSAs purchased through a company like Lively. You get the best of both tax worlds: you’re able to deduct contributions this year, and you don’t have to pay taxes on future withdrawals either.
These accounts come with plenty of limitations, however. First, they can only be used in combination with a high-deductible health care plan. In 2020, that means a minimum deductible of $1,400 for individuals, and $2,800 for family health insurance plans.
Second, individuals can only contribute up to $3,550 in 2020, or $7,100 for families. Account holders age 55 and older can make an additional $1,000 catch-up contribution, similar to IRAs.
Finally, the money must be used for health care expenses. But that category is rather broad and allows not just for doctor’s appointments and prescription drugs but everything from birth control to fertility treatments, eyeglasses to orthodontics, dentists to chiropractors.
In fact, many people use their HSA as a secondary retirement account, knowing that they will have no shortage of health care costs as they age. It offers ideal tax protection for anyone with a high deductible health insurance plan.
Income taxes are complicated and time-consuming for everyone involved. While the U.S. tax code allows plenty of tax-sheltered accounts to encourage savings, each also comes with a laundry list of rules, requirements, and regulations that can easily baffle even the most intelligent among us.
Speak with an accountant or tax attorney before you contribute to a tax-advantaged account, to ensure it will give you the tax break you expect. The last thing you want to do is lock your money into a restrictive tax-sheltered account, only to discover you don’t even qualify for the tax benefit.
What combination of tax-advantaged accounts do you use? How are you looking to use them to reduce your taxes even further in the future?