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. (For related reading, see "How Is a Savings Account Taxed?")
- Everybody seems to be encouraging you to save and invest your money to help it grow for the future.
- But interest, dividends, and capital gains received on savings and investments are subject to taxation.
- A Roth IRA, HSA, municipal bonds, and permanent life insurance policies are among the few strategies available to sock away tax-free savings.
The Roth IRA
Roth IRAs are designed to work as retirement accounts, not savings accounts. That being said, Roth IRAs are a wonderful way to earn tax-free interest for your future. 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money you invest in a Roth IRA was taxed before you deposited it, and the interest will not be taxed when the money is withdrawn for retirement. This can be especially appealing if you are young and have many years for that interest to compound before you retire. Millennials, this one’s for you.
While Roth IRAs are traditionally used for retirement, they’re structured in a way that makes them appealing as a short-term savings tool as well.
- You can withdraw the money you put into the Roth IRA initially (but not the interest it earned) at any time without penalty.
- Some purchases and life events allow you to withdraw earnings as well without penalty.
All this makes a Roth a good place to park money you hope you won’t need – knowing that you could get to it if you do need it. Be aware that if you need to withdraw earnings and don’t fit the purchases/life events rules, you will be charged a 10% penalty each time you do so until you’re 59½. You also need to have had the account for five years before the first withdrawal to avoid a tax payment, regardless of age. All the same, tax-free interest earnings from a Roth IRA are a wonderful incentive to save for your future.
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!
- Can pay 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 2018 the FSA contribution limit rose by $50 to $2,650, while the HSA contribution limit rose by $50 to $3,450 for individuals and $6,900 for families.
What these two accounts share is that you contribute to them before you pay income tax on your earnings – thus stretching the dollars you have to spend on healthcare. As the HSA rolls over, you may even earn some tax-free interest on your money. 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, for an FSA) needs for the next year will be, it is worth considering an HSA or FSA.
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 there are 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 tax-free (some, but not all, municipal bonds are exempt from federal, state and even local tax). 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. (For more, see What Is a Municipal Bond?)
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. High-income investors may want to ask their financial advisors about a municipal investment trust.
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 values, such as whole life or universal life. These policies have a death benefit component as well as a cash component which 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
When it comes to savings, every penny counts. 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 savings tools that can help you reach your financial goals.