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Elderly couple dancing in their kitchenIncluding tax-deductible investments in your portfolio can increase your returns since you are shielding a portion of your portfolio’s returns from income tax. If you choose the right tax-deductible investments, you can fund education expenses and medical expenses along with your retirement. Here are several options and their details. Consider working with a financial advisor to find just the right mix of tax-deductible securities to accomplish your goals.

401(k) Retirement Plan

A 401(k) retirement plan is a tax-advantaged plan that is often offered by employers. It reduces your taxable income, because your contribution is made before any money is taken out for taxes. This, in turn, decreases your tax liability. Even though you pay no income tax on your contributions, up to a point, you still have to pay payroll taxes, which fund Social Security and Medicare.

You choose how much to contribute to your 401(k) based on the contribution limits. In 2021, you can contribute up to $19,500 in pretax dollars to your 401(k). Your employer has the option of contributing matching funds. Contributions to a 401(k) are invested in stocks, bonds and other financial securities usually determined by your employer. The earnings from your investments grow tax-deferred. They are taxed, along with the principal, when they are withdrawn after retirement.

You can begin to take distributions from your 401(k) at age 59.5 without any penalty. You must begin to take a required minimum distribution at age 72 or at age 70.5 if you were born before July 1, 1949. The required minimum distribution was suspended in 2020 due to the coronavirus pandemic. It is back, however, for 2021. When you take a required minimum distribution from your 401(k), you have to pay income taxes on it at your ordinary tax rate.

If you make an early withdrawal from your 401(k), it will cost you a 10% penalty plus income tax at your regular tax rate. If you roll over your 401(k), you have 60 days to accomplish the rollover. Otherwise, you will be taxed on the amount of the rollover.

A Roth 401(k) retirement plan is funded with after-tax dollars instead of pretax dollars. This means that you do not pay income taxes on the distributions you take after retirement.

Individual Retirement Account (IRA) – Traditional and Roth

Man calculates benefits of a tax-deferred account

A traditional individual retirement account (IRA) is a retirement account which you fund from pretax dollars. This IRA has similar tax-deductibility features to the 401(k), but it is not tied to a particular employer. Bonds, stock, mutual funds and other financial securities can make up an IRA. The earnings on the investments in the traditional IRA are tax-deferred until you start either making withdrawals or taking the required minimum distribution.

You subtract the contribution you make to an traditional IRA, up to the contribution limit, from your income. This decreases your tax liability. For 2021, the contribution limit is $6,000 per year with an additional $1,000 contribution possible for those 50 years or older.

The traditional IRA contribution begins to decline when you reach certain income limits. For 2021, once your modified adjusted gross income reaches $66,000, your contribution limit starts to decline and ends at $76,000 if you file taxes as single or head of household. If you are married and filing jointly, the contribution limit starts to decline at $105,000. If you are married and filing separately, you only receive a partial deduction.  These contribution limits are not applicable if you are rolling over a 401(k) into an IRA.

Just like with a 401(k), you may begin taking distributions from the traditional IRA at 59.5 It is required that you take the required minimum distribution at 72 unless you were born before July 1, 1949, in which case you must start at 70.5. You pay taxes at your ordinary income rate on distributions from a traditional IRA.

A Roth IRA is funded with after-tax dollars. You bear the tax burden now since your contributions are not tax deductible. When you retire and start taking distributions from a Roth IRA, you do not pay income tax on the withdrawals. If you own a Roth IRA,  you are not subject to the required minimum distribution rules.

The contribution levels for the Roth IRA are the same as for the traditional IRA. The income limit is different. For a Roth IRA, they are $125,000 and $198,000, respectively.

529 College Savings Plan

A 529 college savings plan, also known as a qualified tuition plan, is another of the tax-deductible investments. The 529 plan allows you to save money for future education expenses. Even though the federal government does not allow you to deduct the contributions you make to a 529 plan on your federal tax return, those contributions are often deductible on your state tax return. In some cases, a state may offer a tax credit instead. The rules regarding tax deductibility of contributions are made on a state-by-state basis.

The beauty of the 529 plans, however, is in their tax-deferred growth and tax-free withdrawals. The 529 plans are more like investment accounts than savings account since you can invest in financial assets like stocks and bonds. Your investment can grow and appreciate in value and the earnings are tax-deferred. When a distribution is made for qualified education expenses, the distribution, including the earnings, is not subject to federal or state taxes.

If you take a distribution that is not for qualified education expenses, you could be subject to federal tax on that distribution at your ordinary income tax rate plus a 10% penalty. The Secure Act of 2019 relaxed the rules under which you are taxed for a non-qualified distribution. For example, now the beneficiary of a 529 plan can use any leftover money to pay up to $10,000 in student loan debt.

Health Savings Accounts

"Health Savings Account" written on notebook cover

A health savings account (HSA) is a tax-advantaged investment plan that allows you to save for medical expenses in the future. In order to qualify to set up a HSA, you must be  insured under a high deductible health plan (HDHP). A HDHP is a health insurance plan with a higher deductible and a lower premium. For 2021 health insurance plans to be considered HDHPs, the deductible for an individual must be $1,400 or more and for a family, $2,800 or more. Usually, HDHPs have deductibles higher than these levels.

HSAs have tax-deductibility benefits that can significantly lower your tax liability. The contributions that you make to a HSA are fully tax-deductible. There are yearly contribution limits. For 2021, the contribution limits to a HSA are $3,600 for an individual plan and $7,200 for a family plan. If you are over 55, you can add an extra $1,000.

If you make a withdrawal from an HSA for qualified medical expenses, the withdrawal is not subject to income tax. However, if the withdrawal is for another purpose, you will be penalized. You will pay income tax at your ordinary tax rate plus a 20% penalty. If you are over 65, there is no penalty and you pay taxes on the withdrawal at your ordinary income tax rate.

HSAs are more like tax-deductible investment accounts than savings accounts. You can invest in a wide variety of financial assets like stocks and bonds. Your earnings on the financial assets in your HSA are not taxed. You can also invest in some, but not all, alternative investments. Check with your plan administrator to find out which alternative investments are allowed.

The Bottom Line

There are several options when choosing a tax-deductible investment for your portfolio.  For example, if your income is going to be lower after retirement than before, consider a Roth IRA rather than a traditional IRA. Alternatively, the Roth 401(k) might also be best. You can roll over a HSA from year-to-year and eventually use it as a retirement account. Whatever combination of tax-deferred securities may be for you, making good use of these different investments can help maximize your portfolio returns.

Tips for Investing

  •  Since finding the right mix of tax-deductible investments to maximize your portfolio returns is different for everyone, a financial advisor can provide invaluable counsel on which securities suit your financial plan and strategy. Finding an advisor doesn’t have to be hard. SmartAsset’s free match-up tool makes finding the right financial advisor easy. With only a few questions and five minutes of your time, you’re paired with local advisors who can help. If you’re ready, get started now.
  • Income in America is taxed by the federal government, most state governments and many local governments. The federal income tax system is progressive, so the rate of taxation increases as income increases. Marginal tax rates range from 10% to 37%. Use a federal income tax calculator to quickly get a good estimate of what you’ll owe.

Photo credit: ©iStock.com/LightFieldStudios, ©iStock.com/towfiqu ahamed, ©iStock.com/Andrei Sauko

Rosemary Carlson
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