Posted 19 days ago Making Sense of Tax-Free Retirement Accounts Throughout my life, I’ve used every type of retirement plan out there, including traditional and Roth accounts. Traditional accounts are often contributed to with pre-tax dollars, and then you are taxed when you take the money out. For Roth or “tax-free” accounts, you contribute with post-tax dollars, but your money grows tax-free and you don’t pay a tax when you take distributions. Let’s say you’re starting out in your career and in a lower tax bracket. If you put $10,000 of your savings (post-tax dollars) into a Roth account, and then you invest it in an alternative investment yielding 10%, in 40 years, it would be upwards of $50,000 and you wouldn’t be taxed on that in retirement. If you had used a traditional account and contributed $10,000 that you didn’t have to pay tax on, the results would be much different. Your tax bracket in 40 years would dictate how much you would pay on that $50,000+. If you’re in the 32% tax bracket, for example, you would have to pay roughly $16,000 of that back in taxes, leaving you with only $34,000. Tax free accounts are by far my favorite, as I always knew that I would be in a higher tax bracket later in life. This is the case for many people, who start out in their career and then work their way up to higher paying jobs, get married, start investing, etc. So, what are the different account types, and how can you put them to use in your life? Health Savings Account (HSA) My favorite tax-free account is the health savings account, which anyone is eligible for as long as they have a high deductible health insurance plan. You can contribute $3,600 to the account if you’re single or approximately $6,600 if you’re a family. You can also add another $1,000 for every family member over 55. Let’s say as a family, due to having a few members over 55, you contribute roughly $9,000 a year. If you’re investing that at an ROI of 10%, the account balance can grow substantially. All the money you put into the account is tax deductible during that tax year. You can also withdraw from the account at any time / at any age to cover medical expenses. I have used my HSA for decades, and I own many note investments in it, so it keeps producing income. I have a designated credit card that I use for eligible medical expenses, as an easy way to track and keep proof rather than hoarding physical receipts. Then I can refer to my credit card history to access my account and be reimbursed. Education Savings Account (ESA) The education savings account (ESA) is similar to the HSA, except that contributions are not tax deductible. Funds grow tax-free, and distributions can be taken to cover or reimburse qualified education expenses tax-free. One of the biggest perks is that anyone may establish an ESA for any qualified beneficiary who is under the age of 18 or who has special needs. For example, many clients that I’ve worked with started ESAs for their young children and watched the accounts grow over time. Personally, I love utilizing ESAs for each of my six grandkids. I also like both the Roth 401k and IRA, as each have their own pros and cons. Roth 401K One of the reasons I like the Roth 401K is because it does not have an income limitation and it often bypasses unrelated business income tax involving debt finance income. You must have earned income to open an account, but there is no required threshold for your yearly income. With an IRA, if you borrow money to purchase real estate, you may have to pay a tax on that, but with a 401K you do not. Another reason I like this account type is because you can contribute almost 10 times as much money into a 401K than you can into an IRA, for example. With a 401K, I can contribute from my salary up to $18,000 per year if I make that much or more. In addition, between my salary deferral and company contributions, my account can realize contributions up to $60,000 per year. This is similar to a Business IRA, such as the SEP IRA, except that does not have a salary deferral option. The Solo 401K works similarly to the multi-member company 401K, but it has less testing and expenses because there are no employees other than the owner(s). Contributions and company matches have the same guidelines but are easier to manage. Both types of plans will require filing a tax return (form 5500) when plan balances exceed $250,000. Roth IRA Many people who have a Roth 401K end up rolling it into a Roth IRA, and the main draw for them is that the IRA does not require minimum distributions when you reach a certain age. For example, with a 401K, you are required to start distributions when you reach 72 years old. With an IRA, if you don’t want to take distributions yet, you can leave that money in, yielding returns for years to come. This allows the Roth account to grow for the rest of the owner’s life and 10 years after his death. Note: this was changed from extending through the beneficiaries lifetime to 10 years in the SECURE Act, signed in December 2019. There are income limitations for opening a Roth IRA, however. When the Roth IRA was created in the late 90s by Senator Roth out of Delaware, it was conceived that the tax benefits should not be provided to the wealthy but instead offered to those who are below the income limitations as a method to fight wealth disparity. Roth IRA income limits in 2020 are $139,000 of modified adjusted gross income for singles and $206,000 of modified adjusted gross income for joint filers. The “Back Door IRA” Strategy If you exceed the income limits for a Roth IRA, you might be able to use a conversion as a workaround method, or “back door” method of moving your money into a Roth. In this case, you would contribute to a Traditional IRA, which has no income limit, and then convert it to a Roth. After five years, you would be able to withdraw from the Roth penalty-free. The list above is not an end-all-be-all list of retirement accounts you should consider, but they do offer the powerful benefit of being taxed “on the seed instead of on the crop.” If you’re in a lower tax bracket and believe that you will be taxed at a higher rate later in your life, it may make sense to utilize one of these accounts. Each has played a critical role in helping me save on taxes and build wealth throughout my life. May they contribute to your prosperity as well!