By JP Pedinielli

This is Part 1 in a series of articles where we’ll explore the importance of selecting the optimal mix of tax-preferred savings vehicles to maximize your after-tax savings. 

The U.S. Government has created numerous tax preferred vehicles to incentivize & encourage taxpayers to increase savings.  Understanding the intricacies of each type of savings account is critical if you want to squeeze every penny of return from your savings.  Studies show that tax efficient portfolios can improve annual returns by 1%-2%.  The three most common types of tax-preference savings vehicles are: tax-deductible, tax-deferred, and tax-free.  In order to get the most “bang for your buck” it is necessary to match the mix of these tax-preference vehicles at each stage of life. 

                 

Many investors are familiar with 401(k), IRA and Roth IRA accounts.  These are known as double tax-preference vehicles.   They all offer some combination of a tax deferral of income or appreciation of the account balance plus either a tax deduction for contributions going in or tax-free treatment for account withdrawals. While a double tax-preference is a great benefit,  HSA accounts offer even greater benefits with a triple tax-preference providing a tax-deduction upfront, tax-deferred growth, plus tax-free distributions provided withdrawals are used for qualified medical expenses.  Alternatively, one common single tax preference vehicle is a non-qualified annuity that only offers tax deferral. Note that we rarely recommend an annuity since you can generally obtain the same tax-deferral benefit using a non-dividend paying stock.  The gain is deferred until you sell the stock and tax may be paid at lower capital gain rates if held for more than a year. Holding the stock is also likely to save you a 1% or greater annual fee. 

The trick is to match your savings goals with your expected tax rates throughout your life.  College students may not be paying any tax so the tax deduction vehicle is of no value. So students generally seek tax deferred growth or tax free withdrawals. Workers in their high salary years would prioritize tax deductions as most important.  Net worth, future income & career, potential family inheritances, large future expenses for health or education, & exposure to high debt or uninsurable risks are just a few additional considerations that could impact your selection.  Maximizing your savings through the use of different tax-preferred accounts is sure to help you attain your saving goals sooner. 

Step 1:  Set aside an emergency savings account equal to six months of living expenses. Individual circumstances may call for more or less savings but six months is a great place to start.  Your emergency fund allows you to cover unanticipated costs without having to liquidate other accounts an inopportune time.  Step 2: fund triple tax-free investment vehicles if they are available to you;  it’s hard to go wrong with these accounts since they enjoy deductions from current taxes, grow tax-deferred, and withdrawals are tax-free for qualified expenses.  The HSA account falls into this category.  In 2019, funding of an HSA account is limited to $7,000 for families and $3,500 for individuals.  If you are over the age of 55, there is a catch-up provision so that you can contribute an additional $1,000. Employers often have programs that contribute to these accounts as part of an Employee Benefits Package.  Any amount your employer contributes counts towards the maximum contribution limit.  HSA contributions are limited to individuals and families that are enrolled in a High Deductible Health Plan so make sure your insurance plan is HSA eligible before contributing.  HSA investment programs still have fairly limited investment choices and they often come with high fees.  However, as the amounts contributed to these programs continues to grow, it is fair to expect fees to come down and investment choices to expand. 

Another investment vehicle that may offer a triple-tax-preference are 529 plans.  529 plans offer tax-deferred growth and tax-free withdrawals, as long as the withdrawals are used for qualifying education expenses.  If you live in a state that has income tax you may be able to qualify for a state tax deduction with your 529 contribution making it a triple-tax preference vehicle.

Understanding the different types of tax preference investment vehicles available for your savings is an important step in achieving your financial goals. We will explore the next level of the tax-preference hierarchy in Part 2, so stay tuned.