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Tax Advantaged Accounts: Top 9 Legal Tax Shelters

If you hate paying taxes I have good news for you! Uncle Sam has a whole host of tax advantaged accounts available to you, and the only thing better than a tax shelter is a legal tax shelter!

You have come to the right place to learn where you can stash your cash to keep the IRS’s dirty little fingers off of it. Below is a comprehensive list of the different tax advantaged accounts that you can use to lighten your tax burden.

Each of the accounts have different purposes, limitations and benefits. You should take advantage of multiple types of tax advantaged accounts in order to realize the full benefits that the IRS allows.

Types of Tax Advantaged Accounts

Pre-Tax Account

Pre-tax accounts allow you to take the amount you contribute off of your income during tax season which allows you to avoid paying income tax on the contributions.

They are also called tax deferred accounts because they allow you defer tax payments until a later date. Deferring the tax allows you to hold onto the cash and use compounding gains to increase your returns.

Post-Tax Account

You deposit after tax money into these accounts, meaning you will pay income tax up front. The advantage comes from not having to pay taxes on any of your investment earnings.

Roth retirement accounts allow you to take the cash out without counting it as income once you hit retirement age. This allows you to supplement your income in retirement without raising your tax bracket!

Comparison of Tax Advantaged Accounts

TypePre-TaxPost-TaxRetirementEducationEmployer Sponsored
IRAXX
401k/403b/457XXX
Roth IRAXX
Roth 401k/403b/457XXX
529 PlanXX
Coverdell ESAXX
HSAXXXOptional
FSAXX
AnnuitiesXX
TypePre-TaxPost-TaxRetirementEducationEmployer Sponsored
Tax Advantaged Account Comparison

Tax Advantaged Retirement Accounts

IRA (Pre-Tax) Retirement

  1. IRA (Pre-Tax) – The IRA is the gold standard retirement savings account and there is little reason everyone shouldn’t have one. You can open one almost anywhere and stash $6,000 ($7,000 if over 50) in a tax deferred manner.

    There are income limits to qualify for the tax write-off, so ask your accountant if you aren’t sure. Even if you make too much for the write-off, you can generally still contribute so your savings can grow tax free!
  2. Roth IRA (Post-Tax) – The Roth IRA is the post-tax version of the IRA, and it is also an account that most people should have. You can deposit $6,000 ($7,000 if over 50) just like the standard IRA. The rules for each account are pretty similar, but there are some important differences.

    Being post tax, it is most advantageous to contribute to a Roth when you income is lower and you have a lower tax bracket. Anything you take out later in life is totally tax free.

    There are limitations on income to qualify for a Roth IRA contribution but these can be worked around with a backdoor Roth contribution. If you make more than $139,000 or are married and make more than $206,000 talk to your accountant about a backdoor Roth contribution.
  3. 401(k)/403(b)/457(b) (Pre- Tax) – These accounts are similar to the IRA, however they require employer sponsorship. Many private companies offer a 401(k) while the 457(b) is offered by state and local governments. 403(b) is generally offered to public school employees.

    These plans all have different nuances, but are pretty similar where it counts. They all have a $19,500 personal contribution limit for 2020, which is much larger than an IRA. Employers can contribute even more on your behalf.
  4. Roth 401(k)/403(b)/457(b) (Post- Tax) – Not all employers offer a Roth version, but many do. It functions in much the same way as the Roth IRA. You pay taxes now on your contributions and can pull the money out tax free in the future.

Tax Advantaged Education Savings Accounts

College can be expensive, save for it tax free!
  1. 529 Savings Plan (Post-Tax) – The 529 is a great account for saving for the educational needs of you, your children, or your grandchildren. Contributions to a 529 are allowed to grow tax free and can be withdrawn tax free if used to pay for qualifying educational expenses.

    Some states will also allow a pre-tax deduction on your state income taxes to help you out even more. It is never too late to start a 529, but you should do so as early as possible to give your savings the most time to grow. Check out this guide to setting a good 529 savings goal.
  2. Coverdell Education Savings Account (Post-Tax) – The Coverdell ESA is a less commonly used tax advantaged education savings account than the 529. It is similar in a lot of ways, but there are some important differences. The differences are contribution amounts, contribution restrictions and investment options.

    The Coverdell ESA limits contributions to $2,000 per year, far less than the 529. While a 529 has no income limits, the ESA is limited to those with an adjusted gross income under $110,000 for an individual, or $220,000 for a married couple filing a joint return. Investment options can be better though, as you with an ESA you can invest in whatever you want and you are not limited to the options in your state sponsored plan.

Other Tax Advantaged Accounts

We all have medical expenses, save tax free for them
  1. Health Savings Account (Pre and Post Tax!) – The HSA is probably the most powerful tax advantaged account available to you. You can put money into it pre-tax, let grow tax free, and you can withdraw the money out of it tax free if used on a qualified expense. The HSA provides the best tax advantages you can get, provided you can qualify.

    You will need a qualified high deductible health plan to qualify. Contribution limits can vary based on your specific health plan, but max out at $7,000 per year in 2020. In the unlikely event you save more than you end up needing for your health care you can always withdraw directly from the account penalty free starting at age 65.
  2. Flexible Spending Account (Pre-Tax) –An FSA is similar to an HSA with a few key differences. One key difference is that the FSA contributions can also be used to pay for medical expenses and child care expenses.

    The other major difference is FSA contributions are use it or lose it. You must spend them during the tax year or you will forfeit the money. The contribution limits are $2,650, but make sure you can spend all of that to prevent losing it before you max it out.
  3. Annuities (Either) – If you purchase an annuity with pre-tax dollars, payments from the annuity are fully taxable as income. If you buy an annuity with after-tax funds, you are required to pay taxes only on the earnings. All annuities offer tax-deferred growth, which means taxes on annuities aren’t due until you withdraw money from the annuity.

    Annuities are complicated contracts between you and an insurance company, so you must be careful. If you are hesitant, always reach out to an independent financial fiduciary before you sign on the dotted line.

Diversification of Investment Taxation

You have probably read a lot about diversification of your assets to help protect yourself against unforeseen events. You might also want to put some thought into your future asset’s taxation and whether or not you are diversified there.

Assets can be held in Pre-Tax, Post-Tax or Taxable accounts. All types of accounts will give you different benefits and drawbacks. A diversified strategy will have to investing into all 3 types of accounts.

No matter what your net worth is, eventually you will want to access your money with as few restrictions as possible in order to live the lifestyle you want. Having diversified holdings in taxable, after and pre tax accounts will give you the flexibility to do that without paying more tax than you absolutely have to. Everyone’s situation is unique, so you should get advice from a fiduciary or accountant here.

Summary

The tax laws leave a lot of legal ways to avoid paying taxes. The general hope by the government is that people won’t take advantage of them. Make that a bad bet on Uncle Sam’s part by setting up some tax advantaged savings today.

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