If your income is pie, then the federal government takes a hefty slice each year. A 2020 report from the Tax Foundation found that a single average wage earner in the United States pays about 29.8% of their income in federal taxes. That’s about $18,368 in federal taxes and does not include state and local taxes. The calculations include:
- Income tax: 15.1%
- Employee-paid payroll taxes: 7.1%
- Employer-paid payroll taxes: 7.6%
Payroll taxes fund Social Security and Medicare, and the Tax Foundation calculations include payroll taxes paid by employers because, “…economists generally agree that the burden of both sides of the payroll tax falls on workers.”
If you would like to keep more of your income, tax-advantaged accounts can help. The category includes retirement, health and education savings accounts, as well as savings accounts for people with disabilities.
Individual Retirement Accounts
Better known as IRAs, these accounts provide Americans with opportunities to reduce taxes while saving for retirement. In 2021, anyone with earned income can contribute up to $6,000 to an IRA. If you're over age 50, you can contribute an additional $1,000 for the year. While it’s possible to contribute to multiple IRAs, the maximum combined contribution cannot exceed these limits.
There are different types of IRAs, including:
- Traditional IRAs. If you open and save in a Traditional IRA, your contributions may help reduce your taxes today, since contributions are made on a pre-tax basis. In addition, any earnings grow tax-deferred until you begin to take distributions, which are typically taxed as ordinary income.
- Roth IRAs. Alternatively, Roth IRAs don’t offer a current tax break, since contributions are made with after-tax income. However, distributions are generally tax-free if certain conditions are met. In the meantime, any earnings grow tax deferred. It’s important to note that not everyone can contribute to a Roth IRA. There are income limits that determine whether an individual or a household can make Roth contributions.
- Rollover IRAs. If you saved money in an employer’s workplace retirement plan and you retire or change employers, you may decide to roll over the savings into a Traditional or Roth IRA. A direct rollover from a workplace plan to a rollover IRA allows you to avoid taxes for the moment and keep your savings growing tax deferred.
No matter what type of IRA you choose, the tax advantages allow you to keep more of your money invested and compounding, so your savings can grow more quickly than they might in a taxable account.
Workplace Retirement Savings Plans
Your employer may make it possible for you to save in a qualified retirement plan such as a 401(k), 403(b), SIMPLE, or SEP IRA plan. Contributions made to these plans offer tax advantages that may include tax deductions today or tax-free income tomorrow, in addition to tax-deferred growth of any earnings.
In general, you can contribute far more to a workplace plan than you can to an IRA. For example, in 2021, the maximum annual contribution limits are:
- 401(k): $19,500, with an additional $6,500 allowed for employees age 50+
- 403(b): $19,500, with an additional $6,500 allowed for employees age 50+
- SIMPLE IRA: $13,500, with an additional $3,000 allowed for employees age 50+
- SEP IRA: 25% of compensation, up to $58,000
Some employers also match employee contributions. So, when an employee contributes to the plan, the employer contributes, too. Tax advantages can help you save more than you might otherwise.
Health Savings Accounts
Health care is likely to be a significant expense in retirement for most Americans. Estimates suggest that a 65-year-old couple retiring in 2020 will need approximately $295,000 to pay for health care and medical expenses during retirement.
Health savings accounts (HSAs) offer a tax-advantaged way to pay for health care expenses today and save for future health care costs. If your employer doesn’t offer an HSA, you can open one on your own. You can save in an HSA until age 65, even if you are not working.
In general, individuals enrolled in a high-deductible health insurance plan can contribute up to $3,600 to an HSA in 2021. A household with family coverage may contribute up to $7,200. Anyone age 55 or older can contribute an additional $1,000 in catch-up contributions during 2021.
By contributing to an HSA, you could benefit from a triple tax advantage:
- Contributions are pre-tax if they are made through payroll deductions or tax-deductible if you contribute to an account you open. Either way, they provide a tax break today.
- Any earnings grow tax-deferred, so the accounts have the potential to grow faster than taxable accounts.
- Distributions taken to pay for qualified medical expenses are tax-free.
It’s important to not confuse HSAs with Flexible Spending Accounts (FSAs). Typically, money in an FSA must be used during the plan year or it is lost. Any money saved in an HSA is yours forever.
Education Savings Plans
Another way to reduce your tax bill today is to save elementary, secondary, or college expenses in a 529 savings plan. Typically, 529 plans are offered by states and offer a variety of tax incentives, including:
- Contributions to 529 plans are not federally tax deductible, but they often are state tax deductible
- Tax-deferred growth of any earnings in 529 plan accounts
- Tax-free distributions when used to pay qualified education expenses
Anyone can contribute to a 529 plan—parents, grandparents, family or friends—and there are no annual contribution limits. That said, contributions to 529 plans are considered to be completed gifts for federal tax purposes. For 2021, the gift tax exclusion for individual gifts is $15,000. So, a couple with two children could gift $60,000 (each parent gifting $15,000 to both children) without gift tax consequences.
529 ABLE Accounts
The 2014 ABLE Act makes it possible for Americans with disabilities (that were identified before they reached age 26) and their families to set aside savings in tax-deferred accounts. The money can be used as a supplement to private insurance and public benefits.
ABLE accounts are similar to 529 education savings accounts in that the annual contribution often is determined by the maximum annual gift tax exclusion. However, when an account reaches $100,000, the beneficiary may no longer be eligible for Social Security disability benefits.
Get Personalized Advice
When it comes to investing, it's not how much you earn that matters—it’s how much you keep. With the complexity of tax planning, you might be leaving money on the table. Getting the advice of a professional that takes your whole financial life into account can help you set aside savings for retirement while also saving on your tax bill now.
This information is not intended to be a substitute for a specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
Prior to investing in a 529 Plan investors should consider whether the investor’s or designated beneficiary’s home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state’s qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing.
APMA®, Series 6, 7, 63 Securities Registrations,1 Series 65 Advisory Registration† As a Financial Advisor, Dixon helps clarify client goals and develops financial strategies to pursue them. He spent the first ten years of his career with Merrill Lynch, where he was trained as a FINRA registered financial advisor. He eventually joined a team at Merrill Lynch that served high net-worth individuals and corporate executives. Most recently, he launched a SEC...Read More