8 Tax-Advantaged Strategies for Building Wealth

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By Shelley Murasko

In the labyrinth of personal finance, there are often elements beyond our control. Fortunately, smart financial decision-making can help you navigate the complexities of taxation.

Although tax rules might seem complicated and boring, they’re one of the best ways you can save money.

Did you know that the average U.S. citizen directs 15% of his or her income to federal taxes alone? Thus, mastering the art of tax savings requires a calculated approach. This article explores eight effective strategies to maximize your benefits and secure a better financial future.

All tax information below is based on current tax law and should not be considered as direct tax advice.

#1: Leverage Tax-Sheltered Accounts

Taking advantage of tax-sheltered investments is a smart way to legally reduce your income tax liability. Examples include health savings accounts (HSAs), 529 educational plans, IRAs, 401(k)s, and Roth IRAs. When you understand how each works and follow the tips below, you’ll be able to pocket more of your hard-earned money over time.

  • Make the most of tax-deferred retirement accounts during high-income years

  • ·In lower-income years, focus on Roth IRAs for tax-free growth

  • Learn the benefits of health savings accounts (HSAs) which offer a triple tax advantage and are thus the best of all tax-sheltered accounts if you have a high deductible insurance plan

  • For college savings, 529s can prove helpful

#2: Use Multiple Roth IRA Strategies

You may already be familiar with the advantages of Roth IRAs, including tax-free withdrawals and no required minimum distributions (RMDs). For the 2023 tax year, low-to-middle income earners can make their annual contribution of $6,500 (over age 50 is $7,500) up until April 15th.

If you’re a high earner, however, you may be subject to certain income limits. Here are a few ways to overcome this.

  • To get around the Roth IRA income caps, high earners can explore the "Backdoor Roth" strategy through nondeductible contributions to a traditional IRA, followed by a Roth conversion (though be careful about the “Pro-rata rule” that considers other IRA money)

  • More and more 401(k) plans are offering a “Roth” or “After-tax” contribution option; use this to create some tax diversification for your future retirement

#3: Maximize Health Savings Accounts (HSAs)

When used properly, an HSA allows for a tax break in the year you contribute, tax free growth over time, and a tax free distribution upon withdrawal. It must be paired with a high-deductible health plan (HDHP) and ideally used only for qualified medical expenses which can include paying Medicare premiums. 

  • High-deductible health plans (HDHPs) make you eligible for HSAs

  • Enjoy tax-deductible contributions, tax-deferred growth, and tax-free withdrawals for medical expenses

  • With age flexibility built into HSAs, you may use these monies at any age for medical-related expenses

#4: Early Withdrawal from Tax-sheltered Accounts Can Be an Option, But Use Caution

While tapping into retirement savings may not be ideal, you may want to explore the potential flexibility for early withdrawals. Before doing so, make sure you understand the rules and restrictions for taking your money out of your account prior to retirement.

  • Roth IRA funds can be withdrawn without tax consequences up to the contribution amount if open for five years.

  • Be aware of exceptions for penalty-free withdrawals from IRAs, such as home buying, qualified education expenses, or age 55 withdrawal options if payments are substantial and sequential for five years — known as Rule 72(t)

#5: Let Cashflow Needs Inform Where You Put Your Savings 

While there’s no single order of priority for using tax-sheltered accounts that works for everyone, your unique circumstances should guide you.

During accumulation, tax deferral is equally effective across account types, however, not everyone qualifies for all account types.

So, you are wise to know the rules around availability, qualification, tax-treatment, and timing.

Consider short- and long-term liquidity needs when choosing where to put your money:

  • Long term: Employer sponsored plans, other tax-deferred accounts (Traditional and Roth IRAs, HSAs, etc.)

  • Short term: Taxable accounts and Roth IRAs

  • Make sure to prioritize account types with employer matches

#6: Make Asset-Location Decisions with Taxation in Mind

Before deciding where to invest your money, assess how certain account types will affect your future tax liability.

  • Prioritize traditional IRAs and 401(k)s for bonds and investments generating interest or ordinary income

  • ·Place actively managed stock funds in tax-deferred accounts like traditional IRAs to avoid taxes on annual distributions; these funds can also be a good fit in Roth IRA accounts

  • Allocate remaining shelf space to stock index funds or low dividend stocks if you are saving beyond your tax-deferred accounts

  • Municipal bonds might be considered for a portion of a taxable account if money is needed from this account within five years

#7: Create an Orderly Framework for Account Drawdowns in Retirement

Once you reach retirement and start to draw down your investment accounts, be sure you understand how this will affect you from an annual tax standpoint. Consider the guidelines below before you begin taking money out of your investment accounts.

  • If you've reached Required Minimum Distribution (RMD) age, begin with Required Minimum Distributions (RMDs) from tax-deferred accounts

  • Next, rely on dividends and distributions from taxable accounts

  • Withdraw from taxable accounts by selling investment positions as your third source of income

  • For large one-time expenses, use your Roth IRA to avoid a spike in income

#8: Keep a Lid on Required Minimum Distributions (RMDs) in your 70s

Traditional IRA and employer-sponsored accounts allow you to defer taxes until age 73 (or age 70½ if you reached this age before 2020). At that time, you’ll be required to withdraw and pay taxes on a minimum amount each year. Following the tips below may help reduce your tax burden.

  • If RMDs are a concern, consider using Roth conversions in low-income years between ages 60 to 73 to pull income forward and lessen the future RMD burden down the road

  • After age 70½, make sure all charitable giving is done from your IRA account through checks written out to the charity straight from the IRA; this is called Qualified Charitable Distributions, and it is one of the few ways to get money out of a traditional IRA without generating income tax

In the intricate world of taxation, mistakes can be costly. By incorporating these eight tax-saving strategies into your financial plan, you can more easily navigate the complexities of tax advantages, compound your capital effectively, and secure a prosperous financial future. With a thoughtful approach to tax planning, you can minimize liabilities, optimize growth, and embark on a journey toward financial independence.

 

THIS INFORMATION IS FOR EDUCATIONAL PURPOSES ONLY. FOR TAX ADVICE, PLEASE CONSULT YOUR TAX PROFESSIONAL.