Tax-Free Savings Accounts and Investment Options for Maximizing Your Tax Savings

Tax-Free Savings Options

Most savings accounts—and similar cash storage options like money market funds—typically require you to pay taxes on the interest earned. However, a few specific savings accounts and financial instruments are exceptions to this rule. These alternatives might be worth considering if you want to minimize your tax burden and maximize your savings.

Savings accounts can help reduce your tax liability in two primary ways. Some accounts allow you to deposit money before taxes, lowering your taxable income for that year. Other accounts let your money earn interest without being taxed, decreasing your tax burden in the future.

Key Takeaways

• Interest earned on savings accounts is generally taxed.
• Certain retirement accounts, education savings accounts, and other financial products offer tax advantages, helping you save on taxes.
• Some accounts let you contribute pre-tax money, while others allow your investments to grow tax-free.

Tax-Advantaged Retirement Accounts

Whether you’re just starting your career or nearing retirement, saving for your retirement should be a top priority. Certain tax-advantaged accounts can reduce your taxes, allowing you to save more for retirement.

Individual Retirement Accounts (IRAs)

Different types of individual retirement accounts (IRAs) offer various tax benefits. With a Roth IRA, the money you deposit has already been taxed, so when you withdraw it for retirement, neither the initial amount nor the interest earned is subject to taxes.

On the other hand, traditional IRAs allow you to deduct your contributions from your taxable income, reducing your tax burden for that year. While your money remains in the account, it grows tax-free. However, you must pay income taxes on both your contributions and the interest they earned when you withdraw the funds. SEP and SIMPLE IRAs are variations of traditional IRAs that offer similar tax benefits.

401(k) Plans and Other Similar Savings Accounts

Employer-sponsored 401(k) plans enable you to defer a portion of your paycheck into a retirement account. The money you contribute is not taxed upfront, reducing your total taxable income for the year. Employers may often match your contributions, making these plans even more advantageous.

Like 401(k)s, 403(b) plans are available to public school employees and workers at specific tax-exempt organizations. In contrast, 457 plans are designed for some government and non-profit employees.

In these accounts, the earnings on your investments remain untaxed until you withdraw the funds. At that point, your contributions and the gains will be taxed at your current income tax rate. Additionally, since 2006, some employers have offered a Roth 401(k) option. Like a Roth IRA, this option allows you to contribute after-tax dollars, so your withdrawals during retirement are tax-free. However, employer-matched funds will be taxable upon withdrawal, similar to a traditional 401(k).

Flexible Spending Accounts and Health Savings Accounts

Flexible spending accounts (FSAs) and health savings accounts (HSAs) offer tax relief while helping you cover healthcare expenses and, in some cases, childcare costs. Although their names are similar, there are critical differences between the two.

FSAs

• Must be set up by an employer.
• Require you to decide on a contribution amount at the start of the year, which generally cannot be changed.
• Do not allow funds to roll over; any unused money is forfeited.
• Can be used for both healthcare and childcare expenses.
• Do not require you to have a high-deductible health insurance plan.

HSAs

• Can be opened independently, without employer sponsorship.
• Available to anyone with a high-deductible health insurance plan.
• Allow funds to roll over yearly so you will retain all unused money.
• Can earn interest on your contributions.
• Can only be used for qualified healthcare expenses.
• Can serve as an additional source of retirement savings.

Health savings accounts are available to individuals with a high-deductible health plan. According to the IRS, for 2023, a high-deductible health plan is defined as having a minimum annual deductible of $1,500 for individual coverage or $3,000 for family coverage.

Additionally, under a high-deductible plan, annual out-of-pocket expenses for 2022 can be at most $7,050 for individual coverage or $14,100 for family coverage. These limits rise to $7,500 for individual coverage or $15,000 for family coverage in 2023. Out-of-pocket expenses include deductibles and co-payments but exclude monthly insurance premiums.

The annual contribution limit for an HSA in 2022 is $3,650 for individuals and $7,300 for families. These limits increase to $3,850 for individuals and $7,750 for families in 2023.

Both FSAs and HSAs share the advantage of allowing you to contribute pre-tax money, effectively stretching the dollars available for healthcare expenses. If you anticipate significant medical expenses or have upcoming procedures not fully covered by insurance, and you can estimate your needs for the next year, one of these accounts could be a valuable tool.

Limited-purpose FSAs are specialized FSAs that you can use alongside an HSA. They cover vision, dental, and medical expenses once you meet your insurance deductible.

Education Savings Accounts

College or other educational expenses represent a significant financial burden, so many people save money for this purpose. Certain savings accounts can help reduce your taxes while saving for education.

529 Accounts

A 529 plan allows you to save for both K-12 education and post-secondary education costs. (Previously, only post-secondary costs were eligible.) There are two main types of 529 plans: prepaid tuition plans, which let you pay for future attendance at certain schools at current tuition rates, and savings plans, which invest your contributions and let them grow tax-free. Many states also offer tax benefits for contributions made to a 529 plan.

Coverdell Education Savings Accounts

Similar to a 529 plan, a Coverdell education savings account is a trust or custodial account that can be used for elementary, secondary, or post-secondary education expenses. Withdrawals are tax-free when used for qualifying expenses. However, any money remaining in the account when the beneficiary turns 30 must be distributed and will be subject to taxes. In contrast, 529 plans have no age limit for the beneficiary.

Municipal Bonds

Municipal bonds, or “munis,” are bonds issued by local governments to finance public improvement projects. These bonds typically offer a fixed rate of return over a set period. Short-term bonds mature within one to three years, and long-term bonds may mature for up to a decade.

The interest earned on municipal bonds is exempt from federal taxes to encourage investment in local government projects. Some municipal bonds are also exempt from state and local taxes if you live in the state where the bond was issued.

While municipal bonds generally offer lower interest rates, they are considered low-risk investments. This makes them attractive to individuals in high tax brackets seeking to reduce their tax burden while still earning interest. They are also popular with older adults who prefer low-risk investments.

A unique advantage of municipal bonds is the opportunity to invest in your local community. By purchasing municipal bonds from your city or town, you can support local projects while earning tax-free interest on your savings.

You can choose to invest in a municipal bond fund as an alternative to investing directly in municipal bonds. To remain exempt from state and local taxes, you must live in the state where the bonds are issued.

Permanent Life Insurance

A lesser-known strategy for accumulating tax-free growth and income involves using permanent life insurance policies with a cash value component, such as whole life or universal life insurance. These policies combine a death benefit with a cash value that can be borrowed against or withdrawn while the insured is still alive.

The cash value in these policies grows yearly at a modest rate through dividends, often not subject to taxation. If you withdraw the money you have contributed (the principal), you won’t have to pay taxes. Alternatively, you can borrow against the policy’s cash value tax-free and allow the policy dividends to cover the interest charges.

What are some examples of tax-advantaged retirement accounts that can help cut your tax bill?

Investing in individual retirement accounts (IRAs) and 401(k) plans can help you retain more money. A Roth 401(k) allows you to make after-tax contributions, so your withdrawals during retirement are tax-free. Public school employees can contribute to a 403(b) retirement plan. In contrast, particular government and non-profit employees have access to 457 plans.

What College Savings Accounts Might Help Consumers Pay Fewer Taxes in the Long Run?

Savings in a 529 or Coverdell education savings account are withdrawn tax-free if used for qualifying education expenses. The 529 plan was expanded in 2017 to cover K-12 education and in 2019 to include apprenticeship programs. With a Coverdell account, any remaining funds must be distributed when the beneficiary turns 30. At this point, they are subject to taxes.

The Bottom Line

Savings accounts are usually taxed on the interest they generate. However, you can stretch your money further by investing in tax-free accounts. While each type of tax-free financial instrument has limitations, they are all valuable tools that can help you achieve your financial goals.