Take advantage of the Tax advantaged accounts

Some investors spend many hours researching stocks, bonds, mutual funds and ETFs yet can overlook easy ways to boost asset growth by harnessing tax efficiencies. There are several tax savings strategies and today we will talk about the easiest one – using tax advantaged accounts.

The most common ones are 401K, IRA, Roth 401K, Roth IRA, 529 (educational savings account) and HSA (Health Savings Account). They differ not only by their purpose and contribution limits but also by the tax benefits they provide:

401Ks and IRAs retirement accounts offer double tax benefit: contributions are deducted from federal tax income and investments grow tax deferred.

Roth 401Ks and IRAs are the “opposite” of “traditional” ones. Instead of deferring taxes, they accelerate them: your contributions are not deducted from the taxable income the year they are made, yet the investments grow tax free and you withdraw them tax-free.

Each of these accounts have different limits and terms that you should research, yet from the pure tax standpoint it make sense to chose Roth over “traditional” 401K / IRA if you expect to be in a higher federal tax bracket in the future when you withdraw your funds (typically, in retirement).

529 accounts Рthese are educational accounts often used to fund college expenses (and to a certain limit Рfor K-12 educational expenses as well). Similar to Roth accounts, contributions are made with after-tax money, and earnings grow federal tax-deferred with withdrawals for qualified educational expenses being tax free. Plus in some states, you can get a state income tax deduction if you contribute to your home state’s 529 plan.

Health Savings Accounts (HSA) – this is by far our favorite account in terms of tax benefits. They are also the least understood and often confused with the much more limited FSAs. The only structural limitation of the HSA is that you have to have a High Deductible Health Plan to be able to contribute to this account. HSAs are also on the lower side of the limits on the amount you can contribute annually (e.g., in 2020 a married couple can contribute up to $7,100). The beauty of the HSAs is that they are triple+ tax advantaged: you contribute pre-tax, money grows tax-deferred and withdrawals for qualified medical expenses are tax free. In case your employer deducts HSA contributions from your payroll, you get additional tax benefit in the form of FICA (Social Security and Medicare) tax savings.