6 tax advantages you didn't know you get with savings accounts
March 31, 2016
While taxes may be almost as certain as death - or so the old saying goes - that doesn't mean you have to give up a huge chunk of your income to the government each year. Instead, you can use perfectly legal means to reduce your taxes and keep more money for yourself. The solution lies with your savings accounts.
Here are six tax advantages you may not know you had with savings accounts:
1. Tax deductions for retirement savings
If you put money into a regular savings account, you won't save any money on taxes. In fact, you may pay more if you rack up enough interest.
However, the government really wants you to save for retirement so if you put that same money in a traditional 401(k) retirement plan or an individual retirement account (IRA), you'll get to deduct it from your taxable income. What's more, that money grows tax-deferred so you don't have to pay taxes on the gains until you start making withdrawals in retirement.
To sweeten the pot, some employers will match worker contributions to a 401(k), up to a certain amount.
"With those matching dollars, you can't get a better return than that," says Greg Hammer, investment advisor representative and owner of Hammer Financial Group in Schererville, Indiana.
2. Tax-free money after age 59 ½
If you'd rather have tax-free savings in retirement, skip the traditional 401(k) and IRA and look for the Roth 401(k) and Roth IRA versions instead. You don't get a tax deduction upfront with deposits in these savings accounts, but the money grows tax-free and can be withdrawn tax-free once you hit age 59 ½.
For young adults who have decades until retirement, being able to let that money grow tax-free can reap significant savings.
For example, a 25-year-old who puts $200 away every month until age 65 will have nearly $305,000 in their account when they retire, assuming a 5 percent annual return on the investment. However, they will have only contributed - and paid tax - on $96,000 of that amount. The rest is tax-free in a Roth account.
Despite the huge savings, "a lot of people out there don't understand their employee benefits," says Aries Jimenez, a financial life planner with San Diego Wealth Management.
As a result, many workers don't even realize a Roth 401(k) is an investment option in some workplaces.
3. Potential for reduced taxes both now and later
There's no need to choose whether to get tax savings now or tax savings later. The government lets you have both.
Depending on your employer's policy, you may be able to contribute to both a traditional 401(k) and a Roth 401(k) at the same time. What's more, you can split your IRA contributions between the Roth and traditional options so long as you don't exceed $5,500 in annual contributions between the two accounts.
"What we'll recommend is [workers] go get their matching contribution from their employer [401(k) plan] and after that, contribute to a Roth," says Scott Cousino, a certified financial planner and owner of Legacy Capital Planners in Grand Rapids, Michigan.
He then suggests people go back to their 401(k) to continue saving once they reach the $5,500 contribution limit.
4. State tax incentives for college savings
Maybe saving for your kid's college education is foremost on your mind. There's good news for you, too, since many states offer tax deductions or credits for money put into college savings accounts known as 529 plans.
For example, Indiana residents who put money into a CollegeChoice 529 plan get a 20 percent state income tax credit, up to $1,000. The availability and amount of deductions or credits vary by state, and you typically have to be investing in your state-run plan to get the benefit.
"If I put in $4,000 and it's worth nearly $5,000 [with the tax credit], I don't know any better plan than that," Hammer says. "When people are doing their 529 plans, they really want to investigate their state's plan."
5. Tax-free withdrawals from college savings accounts
Another bonus of 529 college savings accounts is that the money is tax-free when withdrawn, assuming it's used for qualified education expenses.
"[529 plans] are really powerful tools for those looking to contribute savings for college," Cousino says.
Coverdell Education Savings Accounts, also known as Education IRAs, have a lower contribution limit than 529 plans, but they offer tax-free withdraws for education expenses.
"You can use that money for private school, for elementary school," Jimenez notes.
6. Triple tax savings for medical expenses
Health care costs continue to climb, but those who have a qualified high-deductible health insurance plan can find tax relief by opening a health savings account.
Money deposited into the account is tax deductible immediately. That cash then grows tax-free, and it can be withdrawn tax-free for medical expenses. If you hit age 65 and still have money in your account, you can begin pulling it out for any reason, the same as you would with a traditional IRA or 401(k).
It's treated similarly to an IRA contribution, but it doesn't count toward the IRA contribution limit.
"That's a big deal," Cousino says.
If you put your money into the right savings account, you can reap the rewards of these tax advantages. If you have questions about how these tax benefits work, it's always best to consult with a professional because as Jimenez says, "That's the one thing about taxes - there are a lot of rules."
Comment: Have you experienced tax savings with these savings accounts?
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