Tax-Advantaged Savings Options for Workers

By Lindsay Frankel
Inside Subprime: Oct. 15, 2020

For workers who want to be able to afford life’s expenses, both planned and unexpected, saving is key. But keeping money in a checking account is a missed opportunity for that money to grow. And while you should keep an emergency fund accessible in a high-yield savings account, stashing all your savings in such an account means paying annual taxes on your earnings. 

If you want to save more of your income, a tax-advantaged account is the way to go. These accounts either exempt you from paying taxes entirely, allow you to defer paying taxes until you withdraw the money later, or allow you to take future withdrawals tax-free. And they can help cover some of life’s biggest expenses, such as retirement, college, and healthcare costs. Here’s what you need to know. 

Retirement Savings Vehicles

One-quarter of non-retirees have nothing saved for retirement age, and only 37 percent report that they are saving enough for retirement, according to a recent report from the Federal Reserve. And a 2019 survey found that over half of Americans aren’t even aware of the dollar figure they’ll need to retire comfortably.  Financial planners typically recommend saving 15 percent of your pre-tax income annually for retirement, including any contributions from your employer. 

While 55 percent of non-retired adults participate in an employer-sponsored plan, not everyone has access to one. Here’s what you need to know about the most popular retirement savings vehicles available to you. 

Traditional 401(k) Plan, 403(b), and 457 Plans

Most larger employers offer some type of employer-sponsored retirement plan, and some also make contributions to these plans on behalf of employees. In 2020, you can contribute up to $19,500 per year and up to $25,000 if you’re 50 or older. You won’t have to pay taxes on the income you contribute until you withdraw the funds in retirement, which you’ll be able to do after age 59.5. 

Once you reach age 70.5, you’ll be required to take minimum distributions. But at that time, you’ll likely be in a lower tax bracket. If you need to withdraw funds before age 59.5, you’ll be subject to a 10 percent penalty. 

403(b) plans work almost exactly the same way for employees of non-profit organizations. And 457 plans serve employees of state and local governments. Some employers may offer a 401(k) or 403(b) in addition to a 457 plan, in which case you would be allowed to fund both. 

Traditional IRA

Anyone under 70.5 with earned income can contribute to a traditional IRA. The maximum annual contribution is $6,000 in 2020, and individuals age 50 and older can contribute an extra $1,000 per year. You can also rollover as much as you want from a 401(k) into a traditional IRA if you leave your job. You won’t pay taxes on the money until you withdraw it in retirement. 

However, you will be subject to income limits if you are also eligible for an employer-sponsored plan, which means if you make too much money at a job with a 401(k), you won’t be eligible for the IRA contribution deduction. 

As with employer-sponsored plans, you’ll incur a 10 percent penalty if you take an early withdrawal from a traditional IRA before age 59.5. 

Roth IRA

Contributions to a Roth IRA are not tax deductible, but you don’t have to pay taxes on any earnings or qualified distributions. Unlike a traditional IRA, there are income limits to a Roth IRA. For example, you can’t contribute to a Roth IRA if you’re single and earning $139,000 per year or more. But if you meet the income requirements, you’ll be able to contribute up to $6,000 per year and up to $7,000 if you’re 50 or over. 

You can open a Roth IRA at any age, and you’ll be able to take distributions once the account has aged five years and you’re 59.5 or older. Early withdrawals are subject to a 10 percent penalty. 

SEP IRA

A Simplified Employee Pension IRA allows small business owners and self-employed people to contribute a much larger amount annually than traditional or Roth IRAs. This type of account is tax-deferred, so you won’t pay taxes until you take distributions, which become mandatory at age 70.5. Early withdrawals taken before age 59.5 are subject to a 10 percent penalty. 

In 2020, contributions to SEP IRAs are capped at the lesser of $57,000 or 25 percent of the employee’s income. This can be a great option for freelancers or gig economy workers, as well as small businesses with few employees. 

Education Savings Plans

The average college tuition at National Universities ranged from $11,260 to $41,426 for the 2019-2020 school year. If you don’t want your child to struggle under the burden of student debt, it’s important to start saving for college early. A savings account is also a strong predictor of a child’s future academic success; one study found that a low or moderate-income child with a small dollar savings account is more than three times more likely to attend college and four times more likely to finish college than their peers without savings accounts. 

529 Plans

Contributions to a 529 plan aren’t tax deductible, but you won’t need to pay any taxes on your earnings or withdrawals for qualified educational expenses. These plans are state-run, and lifetime contribution limits vary by state. The law also requires that the balance not exceed your expected expenses. Withdrawals not used for educational expenses will incur a 10 percent penalty. 

Coverdell Education Savings Account

These accounts grow tax-deferred just like a 529 plan. However, you’ll face penalties if your child doesn’t use the funds before age 30. You can contribute up to $2,000 per child annually, but there are income caps at which you can no longer contribute. 

Savings for Healthcare Expenses

Americans spent an average of $4,968 on healthcare costs in 2018. Tax-advantaged savings accounts are one way to prepare for what can be an overwhelming expense. 

Health Savings Account

An HSA is a completely tax-exempt account from which you can withdraw funds to pay for qualifying medical expenses. To be eligible, you need to be enrolled in a high-deductible health insurance plan that meets certain requirements. Contribution limits are $3,550 for 2020, or $7,100 for families. Any withdrawals not used for qualifying healthcare costs are subject to a penalty. 

Flexible Spending Account

Similar to an HSA, this tax-exempt account can be used to pay for out-of-pocket medical costs. You can contribute up to $2,650 per year, and the money follows a “use it or lose it” rule. While you can’t use the funds for insurance premiums, you can use it for deductibles, copayments, and medications. 

The Bottom Line

The less you have to pay in taxes, the more you’ll accrue wealth over the course of your life. And many of these accounts also accrue interest, so you can watch your money grow. For example, a 401(k) account typically sees an average annual return between five and eight percent. Take advantage of these tax-advantaged savings options, and you’ll end up with a larger nest egg to rely on in retirement. 

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