Most savings accounts—and similar places to park your cash, such as money market funds—require that you pay taxes on the interest that you earn. A few types of savings accounts and other financial instruments are exceptions to this rule and might be worth considering if you are seeking ways to reduce your tax bill and stretch your savings.
There are two ways that savings accounts can reduce your tax bill. Some accounts let you deposit pre-tax money, reducing your taxable income in the year you make the contribution. Other accounts allow the money you put in to earn interest tax-free, reducing your tax burden in the future.
- In most cases, the interest earned on savings accounts is subject to taxes.
- Using certain types of tax-advantaged retirement accounts, education savings accounts, and other savings vehicles can help you save money on taxes, so you have more in savings.
- Some of these accounts let you contribute pre-tax money, while others let your money grow tax-free.
Tax-Advantaged Retirement Accounts
Whether you're just starting your career or closing in on retirement, saving for retirement should be a high priority for your savings. Using certain types of accounts for these savings will lower your taxes, leaving you with more retirement savings in the long run.
Individual Retirement Accounts (IRAs)
There are several types of individual retirement accounts (IRAs) that help you save on taxes in different ways. The money you invest in a Roth IRA was taxed before you deposited it, and the interest will not be taxed when the money is withdrawn for retirement. Nor are you taxed on any of the interest paid into the account before it is withdrawn.
Traditional IRAs let you deduct the amount you contribute from your income, lowering your tax burden for that year. While your money is in the account, it grows tax free; you pay no taxes on the interest it earns. However, when you take the money out, you'll have to pay income tax at your current rate on both your deposits and the money they earned while in the account. SEP IRAs and SIMPLE IRAs are both types of traditional IRAs.
401(k) Plans and Other Similar Savings Accounts
Employer-sponsored 401(k) plans let you defer part of your paycheck towards a retirement account. You aren't taxed on any income you put into a 401(k) so, for every dollar you contribute, you lower your total taxable earnings for the year. In some cases, your employer may contribute to the account as well, making it even more advantageous. 403(b) plans are similar accounts for public school employees, while 457 plans are available to certain government and non-profit employees.
In all these accounts, earnings on your investments go untaxed until you withdraw your funds. Then, both contributions and earnings are taxed at your current income tax rate. In addition, since 2006, the 401(k) has had a Roth 401(k) option, at employers that chose to offer one. As with a Roth IRA, you set aside post-tax income and do not get a deduction for your contribution. But the account grows tax-free and there are no taxes on withdrawals. Employer matching funds, if any, are taxable upon withdrawal, as with a regular 401(k).
Flexible Spending Accounts and Health Savings Accounts
Flexible spending accounts (FSAs) and health savings accounts (HSAs) are programs that help provide some tax relief while helping with healthcare expenses and, in the case of FSAs, childcare expenses, too. Although the names sound similar, there are some key differences.
- Must be sponsored by an employer.
- Must be set up with a deposit amount that usually must be declared at the start of the year and cannot be changed.
- Do not roll over—if you don’t use the money you lose it!
- Are available for both healthcare and childcare expenses.
- Don’t require that you have a high-deductible health insurance plan.
- Do not require an employer sponsor.
- Can be opened by anyone with a high-deductible health insurance plan.
- Can be rolled over year to year—you don’t lose your money if you don’t spend it.
- Can earn interest.
- Can only be spent on qualifying health-related expenses.
- Can serve as an extra source of retirement savings.
For 2020 and 2021, the FSA limit is $2,750, while the HSA contribution limit is $3,550 for 2020 and $3,600 for 2021 for individuals and $7,100 for families in 2020 increasing to $7,200 in 2021.
What these two accounts have in common is that you contribute to them before you pay income tax on your earnings—thus stretching the dollars you have to spend on healthcare. If you have one-time or recurring medical expenses or an upcoming procedure that is not fully covered by insurance, and you have a good estimate of what your medical (and childcare) needs for the next year will be, it is worth considering one of these accounts.
Limited purpose FSAs are special types of FSAs that you can have along with an HSA. They can be used for vision and dental expenses, and for medical expenses once you meet your insurance deductible.
Education Savings Accounts
College or other education costs are another big expense and reason that people save money. Certain savings accounts can help by reducing the taxes you pay.
A 529 plan now lets you save for both K-12 education and post-secondary education costs. (Previously only post-secondary costs were allowed.) There are two main types: prepaid tuition plans, which let you pay now for future attendance at certain schools (locking in current tuition rates), and savings plans, which are invested and grow tax-free. Many states also offer tax benefits on the money you contribute.
Coverdell Education Savings Accounts
Similar to a 529, a Coverdell education savings account is a trust or custodial account that can be used to pay for elementary, secondary, or post-secondary education expenses. Distributions are tax-free when made for qualifying expenses, though any money remaining in the account when the beneficiary turns 30 must be distributed and is then taxed. By contrast, there is no age limit for the beneficiary of a 529 plan.
Municipal bonds (or “munis”) are bonds sold by local governments to support public improvement projects. They generally have a fixed rate of return and a set length of time. There are short-term bonds, which mature in anywhere from one to three years, and long-term bonds, which don’t mature for more than a decade.
To encourage investment in local government projects, the interest earned on municipal bonds is free from federal taxes (some, but not all, municipal bonds are exempt from state and even local tax if you live in the state in which the bond was issued). Munis pay relatively low interest rates, but most are considered to be low-risk investments. These bonds are popular with people in high tax brackets because they help reduce their tax burden while still earning interest and with older adults because they are generally low-risk investments.
An added bonus: Investing in your own city or town's municipal bonds allows you to support projects in the community where you live. You receive improved public resources while earning tax-free interest on your savings.
One alternative to investing directly in a municipal bond is to choose a municipal bond fund. If you want to be exempt from state (and even local) taxes, you need to live in the state where the bond is issued.
Permanent Life Insurance
Perhaps a less-known way to accumulate tax-free growth and income is through the use of permanent life insurance policies that carry cash value, such as whole life or universal life. These policies have a death benefit component, as well as a cash component that may be borrowed against—or drawn down—while the insured is alive. This money grows each year at a modest rate via dividends, which may not be subject to taxation in many cases. If you withdraw money that you have contributed (the basis) you will not have to pay any taxes. Alternatively, you can borrow against the cash value of your policy tax-free and let the policy dividends cover the interest expenses.
The Bottom Line
Savings accounts are usually taxed on the interest they earn. So if you are able to invest in a tax-free account, you will be able to stretch your money even further. Although each type of tax-free instrument has its limitations, they are all tools that can help you reach your financial goals.