Tax season can be a frustrating time for many Americans. While getting a check back from Uncle Sam feels good, you have essentially provided him with an interest free loan. In that light, owing money isn’t all bad because it means you were the beneficiary of an interest free loan during the year, though somehow it doesn’t feel like winning.
Regardless of which of these situations you find yourself in, there are many ways to reduce your income tax burden in the realm of financial planning.
In the spirit of tax season, let’s run through a few of the commonly used savings methods that may also provide tax benefits.
- The most widely applicable tax advantaged instruments are the 401(k) and IRA. Both are used to accumulate retirement savings and both can provide tax deferred growth while reducing your taxable income.
The 401(k) and IRA come in two flavors: Roth and Traditional. The key to determining which is right for you is entirely in the taxes. The goal is to pay the least amount of taxes. So your election should depend on when you project to be in the higher tax bracket.
With the Roth account, you pay the taxes now and withdraw them tax free in retirement. This would be appropriate if your retirement income will be substantial, as is likely to be the case for many younger workers with forty plus years of contributions ahead of them.
The Traditional account is funded with pre-tax dollars, thereby reducing your taxable income during the period in which the contributions are made. This is ideal if you are in a higher tax bracket today than you are likely to be in during retirement. If you are searching for a way to reduce your current annual taxable income, the Traditional product is the way to go.
- Another very useful tax advantaged savings plan is the 529 plan. The 529 plan is an education funding plan and can be an excellent way to save for college. Earnings are not subject to federal taxes and are generally not subject to state taxes either as long as they are used for qualified education expenses. Though not applicable in Florida, many states offer 529 plans with state tax advantages as well.
- Life insurance is another product offering considerable tax advantages. Proceeds from the death benefit are tax-free to the beneficiary and there are also ways to structure certain life insurance products to provide tax free streams of income during retirement. The latter benefit is best structured carefully with the help of an investment professional.
- There are a number of ways to take advantage of dividend and capital gains treatments on investments as well, but those specific strategies are not as widely applicable and are beyond the scope of this discussion. For more information, please call our office at 850.300.7055.
- My final piece of tax savings advice was previously alluded to and is already being enjoyed by nearly all of my readers- live in a state with no state taxes. With many states imposing upwards of 10 percent state tax rates, Florida is a welcome ray of sunshine.
Cheer up this tax season. Either enjoy your refund or take solace in the interest free loan you received last year. And, remember, there are many ways to help bolster your financial stability while simultaneously reducing your tax burden.
Waddell & Reed and its representatives do not offer tax advice.
If you withdraw money from a traditional IRA before age 59½, your deductible contributions and earnings will be taxed as ordinary income. You may also be subject to a 10% penalty on early withdrawals. Please discuss with your tax advisor prior to making financial decisions.
Roth IRA contributions are subject to income limitations. You may take nontaxable withdrawals before age 59½ if the Roth IRA is held for at least five years and you meet certain distribution guidelines. Otherwise, an early withdrawal before age 59 ½ may be subject to taxes and a 10 percent federal tax penalty. Please discuss with your tax advisor prior to making financial decisions.
Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing; specific plan information is available in each issuer's official statement, which can be obtained from your financial professional. Be sure to read carefully before investing.
There is the risk that investments may not perform well enough to cover college costs as anticipated. Also, before investing, consider whether your state offers any favorable state tax benefits for 529 plan participation, and whether these benefits are contingent on joining the in-state 529 plan. Other state benefits may include financial aid, scholarship funds, and protection from creditors.
This article is meant to be general in nature and is not intended, and should not be construed as personal financial advice. Please consult your financial advisor prior to making financial decisions. Gary Parsons is a Financial Advisor with U-Vest Financial®, a separate entity from Waddell & Reed and can be reached at 850.300.7055. Waddell & Reed, Inc., Member SIPC. (01/21)