The phrase “tax shelter” may sound sketchy, but the term is a little misleading. Law-abiding citizens can invest their income in several perfectly legal tax-sheltered savings accounts. These savings strategies allow you to reduce your taxable income and keep more cash in your pocket.
A self-employed worker can’t open a 401(k), but if you are employed and your employer offers it, it’s a great way to save for retirement. It lowers your taxable income, and essentially allows you to earn free money.
To fund your 401(k), you contribute pretax income, which reduces the amount of taxes you’ll pay during the year. In addition, your investments will grow tax-deferred, so you’ll pay taxes on them when you withdraw them in the future.
Employers will generally offer a 6 percent match on your contributions. Hitting your contribution limit each year will allow you to fully reap the tax-sheltered savings benefits of your 401(k).
2. Individual Retirement Account (IRA)
Whether you’re self-employed or take home a paycheck from an office job, any individual with earned income can open up an IRA. However, not all IRAs are created equal, so it’s important to choose the type that works best for you as tax-sheltered savings.
With a deductible traditional IRA, your contributions are tax-deferred and tax-deductible. You won’t pay income tax until you begin making withdrawals after turning 59 and a half. These accounts can be beneficial for high-income earners who expect to pay a lower tax rate in retirement.
A Roth IRA won’t reduce your tax burden in the year you pay into the account (and you pay into the IRA with money you’ve already paid taxes on), but your withdrawals in retirement are tax free.
3. Health Savings Account (HSA)
Anyone with a high-deductible health insurance plan is eligible to open a health savings account. You can contribute pretax income to an HSA and reduce your overall taxable income. You can also deposit after-tax income and list those contributions as tax-deductible.
Withdrawals for qualified medical expenses before the age of 65 will not be subject to federal taxes, but on rare occasions, you might incur state taxes. Interest earned on the funds in your HSA will not be taxed.
4. Flexible Savings Account (FSA)
You don’t need a high-deductible health insurance plan to set up a flexible savings account, but you do have to work for an employer who provides this tax-sheltered savings option in your benefits package.
You and your employer agree on a specific deposit amount for your FSA at the beginning of the tax year. The funds deposited can be used for both health-care and childcare expenses.
Your automatic payroll contributions are tax free, and so are qualified withdrawals. However, the money in your FSA will not roll over annually. If you don’t use this, you lose it! But this is a smart tax-deferred savings choice for parents who want to save on ongoing daycare expenses.
The bottom line on tax-sheltered savings
Whether you’re thinking ahead toward long-term goals like retirement or tackling short-term expenses like health care and childcare, tax-sheltered savings accounts can help you manage your money and save a little extra every month.