Making the Most of Tax-Advantaged Accounts
Here's why making the most of a 401(k), IRA, or Health Savings Account can help you lower your taxes, grow your money quicker and reach your long-term financial goals.
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When you think about building wealth, you might think you need to do something big and dramatic. For instance, launch a successful business, become a serial real estate investor, or land a windfall of cash.
But what many people don't realize is that tools for growing your money may be right under your nose. There's financial power to be gained by making the most of tax-advantaged accounts such as 401(k), Roth IRA, and HSAs. These accounts can play a big part in helping you save for retirement.
"Tax-advantaged accounts are important to one's long-term goals because Social Security is only designed to replace about 40% of the average worker's income," says Andrew Wang, a managing partner at the Mendham, N.J.-based financial planning firm Runnymede Capital Management. "You'll probably need anywhere from 70% to 90% of your income during your golden years."
Here's what you need to know, and how you can go about optimizing these accounts with tax benefits:
Grow Your Money Quicker
Probably the biggest reason to invest in tax-advantaged accounts is that you can typically grow your money faster, explains Wang. "Contributions to tax-deferred accounts like an IRA or 401[k] are made with pre-tax dollars, so they are deductible from your taxable income," says Wang. "These investments are also free to grow and compound on a tax-deferred basis. When you're not taxed on capital gains or dividend income, investments can compound at a higher rate."
Understand the Tax Benefits of Different Accounts
Here are the general tax advantages of these accounts:
Contributions made to a Traditional IRA lower your taxable income. There are two main types of IRAs: Roth and Traditional. Both can help you lower your taxable income. The difference is when the tax benefits kick in. With a Roth IRA, you'll receive the tax benefits when you withdraw funds from your account. With a Traditional IRA, your taxable income will be lowered the tax year that you made your contributions.
"Whether you have a Traditional-no taxes on the front end-or a Roth-no taxes on the back end-your nest egg is not taxed while it's growing within the account," explains Jackie Cummings Koski, a certified educator in personal finance based in Cincinnati, Ohio.
Contributions into a Roth IRA account are made with after-tax dollars, which means you are taxed at the time of making the contribution, points out Wang. However, your investment returns grow tax-free.
401(k) contributions are made with pre-tax dollars. Money you put into an employer-sponsored retirement account such as a 401(k) is before any taxes are withheld, reducing your taxable income.
HSAs have triple tax advantages. When it comes to tax savings, HSAs boast a triple threat: Contributions you make are tax deductible, the money grows tax-free while in your HSA account, and you don't have to pay taxes on any qualified medical expenses. "From a tax perspective, they're more advantageous than the traditional or Roth IRA accounts," says Koski.
Know the Difference Between HSAs and FSAs
To make the most of an HSA, you'll want to focus on how they're different from Flexible Savings Accounts (FSA). HSAs are often confused with FSAs, but they are very different when it comes to long-term savings and Investing, explains Koski. For instance, the funds in an FSA are "use it or lose it," meaning they generally cannot not be rolled over from year to year.
HSAs can be rolled over from year to year. Plus, the funds can be invested, just like in a retirement account. A major difference between HSAs and FSAs is that you need to be enrolled in a high-deductible health plan (HDHP) to open and contribute to an HSA. FSAs are provided by your employer. A self-employed individual covered under a qualified high-deductible health plan can open and contribute to an HSA. However, self-employed folks can't open and put money into an FSA.
Here are some ways you can start saving into a tax-advantage account.
Autosave. The easiest thing you can do is to set up automatic contributions so you won't have to debate whether to spend or invest each month. You just need to do it once, then set it and forget it. If you're worried that you can't afford to sock money away, start small. For instance, put 1% of your paycheck into your 401(k), or $50 a month into an IRA.
Bump up your savings. Should you get a raise, commit to bumping up the amount you put into your tax-advantaged accounts. While it seems like a tall order, try to save as much as you can into these accounts. If you get a windfall of cash, such as from a work bonus or tax refund, make a pact with yourself to stash a portion of it away into one of these accounts.
In 2021, the contribution limits for 401(k) accounts is $19,500 per year. If you're 50 or older, you can contribute an additional $6,500. Contributions for IRAs cap at $6,000, with an additional catchup contribution of $1,000 for the 50 and older crowd. Last, for HSAs, you can tuck away up to $3,600 if it's just you, or $7,200 if you're making contributions as a family. The catchup contribution is an extra $1,000 for both individuals and families.
Contribute to a 401(k) first. If you're not sure where to start, Wang recommends maximizing your contribution to a 401(k) first. That way, you'll lower your taxable income. Next, contribute to a Roth IRA. That way, you'll enjoy the tax benefits when you start taking out contributions.
If you have an HDHP and are eligible to contribute to an HSA, stash away as much as you can into an account. Like a 401(k), it can help bump down your taxable income.
By making the most of tax-advantaged accounts, you not only save on taxes but can grow your money quicker. You don't need to start big, own 10 real estate properties, or win the lottery. Instead, inch closer to your goals by making small steps, and gradually build from there.
Jackie Lam is a personal finance writer whose work has appeared in Salon, Business Insider, and GOOD.