As we approach the end of the year, I’ve been fielding more and more questions from clients about reducing income taxes. While there are short-term strategies such as deferring income or accelerating deductions, they provide only temporary relief; they don’t offer long-term consistent tax savings.
To achieve enduring tax savings, consider investing in long-term strategies that may provide tax-free income year after year. Though these vehicles all have certain rules and are designed for specific purposes, several strategies are worth exploring.
529 plan accounts
529s were created by Congress in 1996 to provide a way for parents to save for college for their kids. The earnings within the account are tax-deferred, and the withdrawals are tax-free as long as the money is used for educational purposes. These accounts have grown to offer flexibility, such as changing the beneficiary to another family member and paying K-12 tuition expenses. Student loan repayments are also now considered eligible expenses. Some states also offer tax deductions or credits for contributions to 529 college savings plans.
Health savings accounts
HSAs are a unique way to avoid paying income taxes. These accounts, intended for medical expenses, are funded on a pre-tax basis. The interest earned in the account is tax-deferred, and when the funds are eventually withdrawn, they are tax-free provided they are used for qualified medical expenses. In addition, unused funds can be rolled over into future years and can be used for retirement expenses after age 65, subject to a penalty. The only requirement is to enroll in a high-deductible health plan. In many circumstances, it can be a powerful tax-saving tool.
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Roth IRAs
These are retirement accounts funded with after-tax contributions, where earnings grow tax-deferred. They can provide a tax-efficient way to access funds during retirement without creating a tax burden.
Withdrawals are tax-free once you reach age 59½ and have held the account for at least five years. While early withdrawals are generally subject to a 10% penalty, Roth IRAs can be thought of as accounts that can be used strategically, especially during retirement to provide income without the tax hit.
Cash-value life insurance policies
These policies accumulate cash value based on dividends paid by an insurance company each year and are tax-deferred vehicles. Some policies also have loan provisions that allow you to withdraw money against the cash value. Since the withdrawal is technically a loan, the withdrawal is tax-free. In addition, in most cases, the loans are not required to be paid back.
However, any outstanding loan upon your death is deducted from the death benefit paid to your beneficiaries. In addition, the death benefit paid to beneficiaries is typically income tax-free. Life insurance policies are not traditionally considered a way to generate tax-free income. However, the loan feature could be a way to pay for expenses without increasing income taxes.
Strategies described herein are made possible by the use of policy loans against the cash value of the policy. Policy loans reduce the death benefit of a contract in the amount that is outstanding and may include interest, as well. Employing a strategy using policy loans has the potential to be classified as a modified endowment contract, which poses additional consequences.
Municipal bonds
These are an investment vehicle that can be purchased in a brokerage account. Municipal bonds can be purchased individually, through a mutual or exchange-traded fund (ETF). Typically, municipal bond interest is exempt from federal income tax and, in some states, from state and local taxes. Municipal bonds can provide diversification benefits and a steady tax-free income stream.
Each strategy has its own set of benefits and drawbacks. Before making any financial decisions, consult with your financial adviser and tax adviser to understand the specific implications of your circumstances and to choose strategies that align with your long-term financial objectives. By carefully considering these strategies and seeking professional advice, you can optimize your tax planning and work toward a more secure financial future.
