There are investment accounts that have tax advantages that savings accounts do not have and that can help you avoid paying taxes or use tax advantages to your advantage
There’s a catch to savings accounts that few know about: You pay federal income taxes on the interest you earn on them. You will pay taxes at your regular rate the year you earn interest, whether or not you withdraw from the account. The rich are rich, because they know certain financial secrets (of course, many of them through the professional advisers they surround themselves with) in order to avoid paying taxes. There are some savings accounts that you should put your money in to avoid some tax charges and make it grow like the wealthiest would.
Interestingly, the secret of the rich are very popular accounts in the United States that are not taken advantage of by people in general. You can avoid paying taxes on interest with the help of certain tax-advantaged accounts that are used to finance retirement, health care, and education expenses. These accounts are not suitable for emergency savings, for which money is pooled in regular savings accounts.
Conventional savings accounts, even high-yield ones, pay interest so modest that it’s often insufficient to keep up with inflation. And if that wasn’t enough, the Internal Revenue Service (IRS) expects to receive its cut through the owner’s regular tax rate, which is based on the owner’s income. These taxes must be paid even if the interest remains in the account.
While even these features apply to retirement, health care, and education accounts, there are two ways in particular to be tax-advantaged:
1. Choose an account that allows you to deposit money before taxes (you don’t pay them at the time you deposit).
2. Choose an account that allows the money in the account to grow tax-free (you pay taxes right now).
You will say to me: “what is the advantage if in the end I do have to pay taxes, choose the account I choose?”. And this is where the secret of the rich comes in: the advantage lies in the decision of the account that you decide to have, contemplating what will be the lowest tax rate to pay, either in your present or in the future, if you expect to increase your income in your retirement.
What are tax-advantaged savings accounts?
Individual retirement accounts (IRAs) or traditional 401(k) plans
These accounts, unlike regular savings accounts, do not have to pay taxes in the year that you earn the interest. When interest is withdrawn, it is taxed as ordinary income, unless you make early withdrawals, where you will have to pay a 10% penalty, in addition to being taxed as regular income.
Roth IRAs and Roth 401(k) accounts
Unlike these traditional accounts, you pay taxes at the time of the deposit, so that the interest grows free of tax charges. Unless you withdraw money before age 59½, for which you will incur a 10% penalty in addition to any income tax due, your withdrawals will be tax-free.
Coverdell Savings Accounts (formerly Education IRAs)
These accounts are designed to help parents pay for their minor children’s educational expenses. Interest earned on funds in a Coverdell account can be withdrawn tax-free, but only if the money is used to pay for eligible education expenses.
529 Savings Plans for College Education
A 529 plan allows interest on deposits to grow tax-free and also allows tax-free withdrawals when the money is used for eligible education expenses. Also, a new law allows funds to be transferred to your IRA account for retirement if you don’t use that money.
Health Savings Accounts (HSAs)
An HSA allows its owners to deduct their contributions from current income and also avoid paying taxes on earnings and withdrawals. Like the other account types, this money must be spent on qualified medical expenses to avoid these tax charges.
Flexible Spending Accounts (FSAs)
Another popular account, an FSA, allows homeowners to deduct contributions from current income and also avoid paying interest taxes if the money goes toward qualified medical expenses. FSA funds generally must be used in the year they are contributed. The advantage is that, as the name implies, it is more flexible, since there are non-medical products that could qualify for use before the end of the year.