9 Savings Accounts with Sweet Tax Breaks
Looking for a tax break?
There are several out there. It’s just a matter of choosing one that fits your situation and works towards your goals.
A tax-free savings account (TFSA) can help you both save on taxes in the near term and fund future needs in the long term.
The following are several types TFSA that can help you grow your money for the future.
1. Traditional IRA
IRAs have been popular for decades. Benefits of a traditional IRA include deferred taxes on contributions and investment earnings. Taxes are not paid until the money is taken out of the plan.
Like most tax-advantaged plans, traditional IRAs come with some strings attached:
- As of 2023, annual contributions are limited to $6,500 a year, or $7,500 if you are age 50 or over by the end of the year. Contribution limits are adjusted over time for inflation.
- Your ability to deduct traditional IRA contributions may be reduced if you are covered by a retirement plan at work and exceed certain income limits.
- You and your spouse combined cannot deduct more IRA contributions than the combined amount of your taxable incomes.
- Under most circumstances, if you take money out of the plan before the age of 59 1/2, those distributions will be subject to ordinary income tax plus a 10% penalty.
Who it’s for:
Savers who are not adequately covered by a retirement plan at work, can benefit from a tax deduction, and are willing to commit money until they are at or close to retirement.
How it helps:
By deferring taxes on contributions and investment earnings until retirement, a traditional IRA helps money grow tax-free and possibly may allow the account holder to benefit from being in a lower tax bracket when the money is withdrawn in retirement.
2. Roth IRA
The difference between a Roth IRA and a traditional IRA boils down to whether you want to pay the taxman now or later.
Key conditions for Roth IRAs are:
- Unlike with a traditional IRA, contributions to a Roth IRA are not tax-deductible. Money in a Roth IRA is allowed to grow tax-free and can be withdrawn without taxes once you reach age 59 1/2.
- The amounts you contribute to a Roth IRA can be withdrawn at any age, but investment growth on those contributions will be subject to a 10% penalty if withdrawn before age 59 1/2.
- As of 2023, Roth IRA contributions are limited to $6,500 a year, or $7,500 if you are age 50 or over by the end of the year. Contribution limits are adjusted over time for inflation.
- The amount you can contribute might be reduced if you exceed certain income limits.
Who it’s for:
People who are not adequately covered by a retirement plan at work, are currently in a relatively low tax bracket, and are willing to commit money until they are at or close to retirement age.
How it helps:
While a Roth IRA does not allow you to deduct contributions, it allows those after-tax contributions to grow tax-free and then be withdrawn without taxes once you reach age 59 1/2. By taxing contributions rather than withdrawals, a Roth IRA allows people who are currently in a fairly low tax bracket pay taxes at that low rate rather than at a potentially higher rate once they reach retirement age.
3. Traditional 401(k) Retirement Plan
A traditional 401(k) plan is a benefit offered by many employers. Like a traditional IRA, it gives you a deduction on contributions you make to the plan, though withdrawals from the plan in retirement are subject to income tax.
Key conditions:
- As of 2023, eligible participants can contribute up to $22,500 (or $30,000 if you are aged 50 or over). Contribution limits may be adjusted over time for inflation.
- Some employers add a contribution on behalf of plan participants.
- Contributions and investment gains are tax-deferred, and can be withdrawn at ordinary income tax rates any time after the beneficiary reaches age 59 1/2.
- Withdrawals prior to that may be subject to a 10% tax penalty in addition to ordinary income tax.
Who it’s for:
People whose employer offers a 401(k) plan and who are willing to commit money until they are at or close to retirement age.
How it helps:
A traditional 401(k) plan has similar tax benefits to a traditional IRA. Taxes are deferred on both contributions and investment gains. However, they offer some advantages over IRAs.
First of all, the contribution limits are much higher. Second, some 401(k) plans kick in contributions on behalf of employees. Finally, many 401(k) plans come with investment features that may be tough to obtain as an individual, such as free retirement planning tools and extensive investment option menus.
4. Roth 401(k)
Though not offered by all 401(k) plan sponsors, those that allow Roth accounts give participants the opportunity to benefit from the same tax characteristics as a Roth IRA, but with the higher contribution limits of a 401(k).
Key conditions:
- As of 2023, eligible participants can contribute up to $22,500 (or $30,000 if you are age 50 or over). Contribution limits may be adjusted over time for inflation.
- Some employers add a contribution on behalf of plan participants.
- Contributions are not tax-deductible, but investment gains are tax-deferred and withdrawals after age 59 1/2 are not subject to income tax.
- Withdrawals of investment earnings prior to age 59 1/2 may be subject to a 10% tax penalty in addition to ordinary income tax.
Who it’s for:
Lower-tax bracket employees who are covered by a 401(k) plan at work that allows for Roth accounts and are willing to make long-term saving commitments.
How it helps:
For people in relatively low income tax brackets, a Roth 401(k) can create the same benefit as a Roth IRA of paying taxes now rather than after age 59 1/2, and Roth 401(k)s allow participants to contribute at higher levels than Roth IRAs.
5. In-state 529 Education Savings Plan
These plans are intended for use towards educational expenses.
Here are some key terms of these plans:
- Contributions are subject to annual gift tax limits.
- Contributions are not tax-deductible, but investment earnings are not taxed as long as the money is ultimately used for eligible education expenses.
- In-state 529 plans may offer additional state income tax breaks.
Who it’s for:
People looking to save long-term for education expenses, and who could benefit from both federal and state tax relief on investment earnings.
How it helps:
Having investment gains exempt from tax makes 529 plans most beneficial for people who start saving for educational expenses far in advance. Residents of states with high income taxes may benefit especially by investing in an in-state 529 plan.
6. Out-of-state 529 Plan
You are not restricted to investing in a 529 plan sponsored in your own state. The only drawback is that you may miss out on incentives geared to state taxes.
- Contributions are subject to annual gift tax limits.
- Contributions are not tax-deductible, but investment earnings are not taxed as long as the money is ultimately used for eligible education expenses.
- Out-of-state 529 plans do not qualify for state income tax breaks.
Who it’s for:
People looking to save long-term for education who are in states with little or no state income tax.
How it helps:
Protecting investment earnings from federal income tax is especially beneficial to people who start saving for education early enough to amass significant investment earnings.
7. Coverdell Education Savings Account
The Coverdell Education Savings Account used to be the main way to save for college prior to the creation of 529 plans. The tax treatment is similar but they are subject to different conditions:
- As with 529 plans, money deposited into a Coverdell Education Savings Account isn’t deductible, but investment earnings and withdrawals for eligible education expenses are tax-free.
- However, total contributions to Coverdell accounts on behalf of any given beneficiary can not exceed $2,000 per tax year.
- The beneficiary must be under 18 years old when the account is established, or designated as a special needs beneficiary.
Who it’s for:
Beneficiaries who are under 18 years old or designated as special needs students at the time the account is set up.
How it helps:
It allows money to grow tax free and be withdrawn without taxes as long as it is used for eligible education expenses.
8. Health Savings Account (HSA)
These accounts offer triple tax savings. Contributions are tax-deductible, money grows tax-free, and withdrawals are tax-free when used for qualified medical expenses. You can also amass money in an HSA over time, providing a supplement to your retirement nest egg for use towards future medical expenses.
Conditions include:
- In order to participate in an HSA, you must participate in a high-deductible health plan (HDHP).
- Contributions are tax-deductible.
- Annual contributions for 2023 are limited to $3,850 if you have individual HDHP coverage, and $7,750 if you have family HDHP coverage. These limits are adjusted periodically for inflation.
- Withdrawals can be made any time and are not taxed as long as they are used for eligible medical expenses.
Who it’s for:
Participants in HDHPs who want to set aside money in advance for near-term and long-term medical expenses.
How it helps:
By exempting both contributions and investment earnings from income tax, HSAs provide important tax benefits. Because you can accumulate money over time for use towards future medical expenses, HSAs can not only help you save for near-term medical expenses but can also be an important supplement to your retirement savings.
9. Flexible Spending Arrangement (FSA)
Like HSAs, these allow money to be contributed, invested and withdrawn for medical expenses without taxes. Unlike HSAs though, they are designed to be used primarily for expenses occurring in the same year.
Key rules include:
- Employees can choose to contribute through payroll deduction, and employers may also contribute on behalf of employees.
- For 2023, employee contributions are limited to $3,850. Annual contribution limits are periodically adjusted for inflation.
Who it’s for:
People whose employers offer an FSA plan and who have medical expenses that are regular enough so they can count on using the amount they contribute within the time limit.
How it helps:
People who don’t itemize deductions may benefit from having tax-free money to pay for medical expenses. There is also some slight benefit to having investment earnings free from taxes, though this benefit is limited by the generally short-term nature of these accounts.
Get Help Making Retirement Plan Contributions With a Saver’s Credit
Are you worried you can’t afford to save for retirement?
If your income is below $66,000, you may qualify for a tax credit that helps towards a portion of your contribution to an IRA or an employer-sponsored retirement plan.
Here’s the difference between a tax deduction and a tax credit:
- A tax deduction means that a portion of your income is excluded from taxation.
- A tax credit is money that is credited against any tax you owe.
Dollar-for-dollar, a tax credit is typically more valuable than a tax deduction. For example, consider a $1,000 tax deduction. Even if you were in a 25% tax bracket, you’d save 25% of that amount by having it excluded from your tax bill, or $250.
A tax credit, on the other hand, directly offsets the tax that you pay. So, a $1,000 tax credit would save you a full $1,000 on your taxes, as long as you were due to pay at least that much in taxes that year.
The saver’s credit, formally known as the retirement savings contribution credit, gives lower earners a tax credit equal to a portion of the contributions they make to an eligible retirement savings plan. That portion ranges from 10% to 50%, depending on how much you earn. The maximum credit is $1,000 for single tax filers, and $2,000 for joint filers.
It’s like an extra bonus for saving. You not only get the regular tax advantage that goes with a retirement plan contribution, but you get a tax credit as well.
Who it’s for:
People with limited incomes (less than $66,000 a year for joint tax filers, or less than $33,000 a year for individual filers) who contribute to an eligible retirement plan.
How it helps:
People in lower tax brackets don’t get as much of a tax break by making contributions to IRAs, 401ks, or other retirement plans, but the saver’s credit makes up for that by kicking in an amount equal to part of your retirement plan contribution as a credit against any tax you owe that year.
Next Steps: Start Saving Money on Taxes This Year
Any of the above tax-advantaged savings plans might come in handy at tax filing time, but really the best time to think about them is throughout the year.
After all, you might not be able to come up with a meaningful savings contribution at the last minute while you’re filing your taxes. However, if you contribute steadily to one of these tax-advantaged plans throughout the year, you might find yourself with a much more useful deduction at tax time.
Here are some steps you can take to start saving on taxes:
- Do some financial planning to determine what major expenses you face in the future. These may include health care, education, or retirement. Identifying your future expenses helps determine which types of TFSAs may benefit you.
- Budget money to meet each type of need. Once you’ve identified what type of future expenses you face, estimate the amount of those expenses so you can figure out how much you need to save. A retirement calculator can help you figure out how to save for retirement over the course of your career.
- Match the type of savings account with your future need. You may need more than one type of account to meet your future needs. Figure out how to spread your savings among different types of accounts to meet those needs.
- Determine your eligibility for tax savings. As described throughout this article, contributions to TFSAs are subject to certain limits and conditions. Figure out the extent of your eligibility.
- Decide whether to use an independent or employer-sponsored retirement account. You may already be eligible to contribute to an employer-sponsored retirement plan. If not, you may decide to set up an IRA account on your own. Or, under certain conditions you may be able to use both an employer-sponsored plan and your own IRA.
- Compare bank savings accounts for near-term needs. Near-term expenses like medical bills need money that’s fairly stable and liquid. Consider bank savings accounts or other cash management options for these needs.
- Use investment accounts to help grow your savings for long-term needs like retirement. Compare brokerage investment accounts or robo-advisors for long-term investments.
These steps could make your next tax bill easier to bear, and help you afford major expenses like medical bills, tuition and retirement.
