Want to earn over $2,000,000 tax free and pay less taxes over your lifetime the legal way?

No this is not a Nigerian prince scam. You can really earn over $2,000,000 tax free pretty easily it just takes commonsense, discipline and patience. Read on.

Around this time of year people start thinking about their taxes. In all my years of financial planning I am yet to find a person that wants to pay any more tax then they absolutely have to. While most people want to pay less tax many fail to take advantage of all the tax deferral and tax free accounts available to them. Many people that do use some of these accounts often fail to take the time to make sure they maximize the benefits by using the accounts correctly or timing the contributions to, or withdrawals from these accounts.

I am going to start out with giving you some very simple general rules.

1.       Any time you can put money in an account that grows tax free or tax deferred you are far better off than putting that money in an account that has no tax advantaged status.

2.       The longer you can keep money in a tax free account the better.

3.       If you can avoid paying taxes on some of your income by designating that money to pay for medical or dependent cares expenses you should do it.

4.       If you can shield present income from current taxes that is a good thing.

5.       The longer you can shield income from taxes the better (think of not paying the taxes owed as an interest free loan from the government for the length of deferral.)

The general rules above are really common sense principals and if you follow them and do nothing more you will be much better off than not following them. In the rest of this article I will talk about various accounts that may be available to you to apply the general rules. If future post I will expand beyond that by giving you ideas about how to fine tune the use of these accounts to achieve even greater tax savings over your life time.

One of the best ways to save money is in a tax free or tax deferred account. The most commonly used and understood account is the Individual Retirement Account or as they are commonly called an IRA. There is a traditional and Roth option available to you. The traditional allows you to deduct the amount you put in from this year’s taxes and you pay no taxes on any of the investment returns or money you put in until you take it out. This is the deferred tax (or interest free loan) discussed earlier. If you choose the Roth option you do not receive a tax deduction for what you put in but you will never be taxed on any of the money you earn in the Roth as long as you don’t break the rules when you withdraw the money. 

So if you put $5,500 in when you are 22 and do so every year until you are 65 you will have over $1,436,000 at age 65. You will have contributed only $242,000 leaving you with over $1,200,000 of tax free income. If you have an employer that allows Roth contributions and you increase your total contribution to $10,000 a year between the two accounts your value will be over $2,600,000 at age 65. Almost $2,200,000 of that money will be completely free of any state or federal income tax!

If you did not start your Roth yet and are no longer 22 or can only contribute a lesser amount try downloading this spread sheet to calculate how much tax free income you can generate over different periods of time with different contribution rates. If you just plug in a contribution rate in 1 (C) the spread sheet will do all the math for you. If you want to change the rate of return just change the percent in 1 (E). Just seeing how much tax free income you can generate will hopefully motivate you to do what you need to do.

You contributions to IRA accounts are currently limited to $5,500 a year ($6,500 if over 50) or the amount of your earned income, whichever is lower. Eligibility for the tax deduction on the traditional IRA or to contribute to a Roth is limited if your income is above certain thresholds but most people, especially young people starting out, fall under those thresholds.

Very similar to the IRAs are company sponsored 401K plans. These plans are offered by most employers and many even match a portion of your contributions.  Some employers only offer the traditional option though many are starting to offer the Roth or any combination of the two up to the maximum contribution limit. While IRAs often offer more options and better flexibility than 401Ks, the beauty of the 401K is there are higher contributions limits $18,500 ($24,500 if over 50) and your ability to contribute is not capped by your income. Also you cannot beat the company match if there is one.

You are allowed to have both an IRA and 401k and contribute to each up to their limit. For retirement purposes, if you don’t have a pension, you should be trying to put at least 20% of your income into these accounts in some combination. However if you can’t do 20%, something is better than nothing but if you can do more than 20% remember that the more you put in the more you will reduce your life time tax bill.

All of these accounts impose penalties if you withdraw the money prior to age 60. While there are some hardship and few other exceptions to avoid penalties for early withdraws these accounts are really designed and best used for long term retirement savings. If you are age 60 and over you should put every penny you have available into these accounts because even if you need the money tomorrow you can withdraw it penalty free. (Your 401k may not allow you to directly withdraw money while still employed but there are ways around that through a 59 and a half roll over or taking a loan). While the money is available to you immediately in the year you turn 59 and a half, these are the last dollars you should touch. Remembers General Rules 2 and 5. Since you can take the money out at any time you can now treat them like any other savings account so draw down your taxable accounts first. (For traditional IRAs and 401Ks there are minimum required distributions you must take every year starting at age 70 and there may be tax strategies for converting some of that money to a Roth or taking money out earlier to lower your lifetime tax bill, this will be discussed in future post.)

A lot of factors go into deciding whether the traditional or Roth account is better for minimizing your life time tax bill. Likewise the timing of taking distributions from or converting a traditional into a Roth IRA can greatly affect the best way to minimize your lifetime tax bill. This is more complicated and takes some analysis of your own situation and will be the subject for future note. For now, rest assured either option is far superior to saving money in a taxable account. The more of your long term savings you can put into these accounts the more you will save on taxes, so instead of complaining about paying too much in taxes do something about it. Use these accounts to shelter as much income as possible from the tax man.

There are other accounts where you can save money on taxes that do not have the long term constraints of the IRAs and 401ks. Many employers offer Flexible Spending Accounts (FSA) for dependent care and/or health care. Money you put into these accounts goes in tax free, but you must use the money for its intended purpose (qualified expenses) within the year (and sometimes a short grace period afterward) or you lose the money. So you want to carefully calculate your expenses for the coming year and not put more in them than you are likely to spend. Calculating what you will spend on dependent care is usually pretty easy, number of children times cost per month. Calculating medical can be more challenging, but if you have certain medications you take all the time or routine treatment of any type that can be easier.

The final account that is great for shielding income from taxes is a Healthcare Savings account (HSA). Anyone is eligible for one if they have a high deductible health insurance plan. Unfortunately many people overlook these because they confused them with the FSA where they had to use the money or lose it. That is a shame because with this account the money is yours until you take it out and spend it. There are no time constraints. If you have an employer sponsored plan they will deposit money into an account for you pretax (meaning you pay no federal, state or social security tax on that part of your paycheck) and you never have to pay tax on that money or anything you earn o that money as long as you take it out for a qualified expense. If you leave your employer the account is yours and you can take it with you or roll into another HSA.  If you don’t have an employer sponsored plan you can set up an HSA at your bank or Credit Union and take a tax deduction for your contributions. So if you are in the 24% tax bracket and have a 4% state income tax, add in the Social Security taxes and every thousand dollars you put into ah HSA saves you $350.00 in taxes.

Other than being restricted to taking the money out for qualified purchases (TO AVOID THE TAX AND ANY PENALTY) it is just like any other savings account you have except that all the interest or investment income you earn in it is also tax free. So if you need the money to help you pay a medical bill you can take it out right away and you have already realized a substantial tax savings. However, If you can pay   the medical bill out of another account that is even better.

If your HSA account manager allows you to invest in the stock market all the better. You can turn this into another long term savings account. You can let your HSA grow tax free (remember general principle 2, the longer you can keep your money in a tax free account the better). A lot of people don’t realize they can continue to let the money grow tax free in their HSA for as long as they like and there is no time limit on when you have to take the money out. So if you can pay your medical bills out of your taxable savings account do so. Just keep records, so if you need to dip into you tax free account later, even years later, you can do so to the extent you have medical bills you never redeemed from your HSA account. The IRS does not limit how much you can take out in any one year, the only requirement is that the money withdrawn is less than or equal to an amount you spent for qualified medical expenses. It does not matter how long ago you incurred those expenses as long as it was in a year where you had an eligible HSA. So you can defer the withdrawal and let the money grow tax free unless you have exhausted all your taxable savings accounts.

The HSA contribution limits are $3,450 for individuals this year $6,900 for families. You can add $1,000 more if you are 55 or older. These accounts have unparalleled tax savings and if you can afford to do so you really want to maximize them every year. Even if you are healthy now and don’t spend that much on qualified medical expenses, one of the largest and underestimated expenses in retirement is healthcare. You can start prefunding those expense with tax free dollars now. If you retire early or are laid off you can also use the funds from your HSA to pay your premiums under COBRA. When you are 65 or older you can use funds from your HSA to pay your Medicare premiums. The money will not go to waste, average medical expense for people over 65 are $10,000 a year and climbing.