Smart tax planning is not just claiming all the deductions and credits you are entitled to on your tax return so you can get a bigger refund. It also involves thinking about and engaging in legal methods to lower your tax burden throughout the year. The following are vehicles that can give you a break on your taxes:
- Employer-sponsored retirement plan: Most employers offer a defined-contribution retirement plan (typically a 401(k) or 403(b)). It is called a defined-contribution plan because the contributions to the plan are defined, but the benefits you receive in retirement are not. That is dependent on how much is put into the plan and how well your investments perform. The money that you contribute to a defined-contribution plan is deducted from your paycheck pre-tax, meaning you don’t have to pay income taxes on it. While your money is invested in the plan, you don’t have to pay taxes on the earnings either. You only have to pay taxes on the withdrawals you make.
- Individual Retirement Account (IRA): IRAs are not tied to the employer – you can open one at a variety of financial institutions, such as a credit union, bank, or mutual fund company. In order to contribute to an IRA, you or your spouse must have earned income. The annual contribution limit is higher for employer-sponsored retirement plans, but the investment choices are typically greater for IRAs (and you don’t have to worry about what to do with the plan when you leave your job). With a Traditional IRA, your contributions are tax-deductible, and your earnings while in the plan are untaxed as well. With a Roth IRA, your contributions are not tax-deductible, but your earnings and withdrawals are not taxed.
- Coverdell Education Savings Account (ESA): The Coverdell ESA is a tax-deferred account for education costs. It works just like a Roth IRA – contributions aren’t tax-deductible, but the investment earnings accumulate tax-free, and qualified distributions are exempt from income tax. It can be used to pay for tuition, fees, books, and equipment for primary, secondary, and postsecondary education (kindergarten – graduate school). Contributions can only be made until the beneficiary turns 18 and must be used by the time he or she is 30. Coverdell ESAs can be opened at many financial institutions, and unlike with 529 Plans (discussed more below) your investment options are virtually unlimited. As the plan’s owner, you choose what stocks, bonds, mutual funds, or other opportunities to invest in.
- 529 Plan: The 529 Plan is a tax-advantaged savings vehicle that can be used for college and graduate school expenses. It comes in two basic varieties: the college savings plan and the prepaid tuition plan. College savings plans are investment accounts offered by individual states. (The money is typically put in mutual funds.) Prepaid tuition plans allow you to buy all or part of a future public in-state education at today’s prices. Unlike with college savings plans, you can generally only invest in your state’s plan (if they have one). It may be possible to use the plan at a private or out-of-state public school, but the coverage will likely be less. With both college savings and prepaid tuition plans, you don’t have to pay taxes on the earnings or withdrawals as long as you use the funds for qualified education expenses. Contributions are not deductible on your federal income tax return, but they may be deductible on your state return if you use your state’s plan.
- Medical Expense Flexible Spending Account: Offered through employers, a medical expense flexible spending account is a savings plan that allows you to contribute earnings pre-tax to pay for qualified unreimbursed medical and dental costs, such as co-pays and over-the-counter medication. (It can even be used to purchase Band-Aids!) You can sign up for a flexible spending account during your employer’s open enrollment period.
- Dependent Care Flexible Spending Account: While the medical expense flexible spending account allows you to use pre-tax dollars to pay for medical expenses, the dependent care flexible spending account allows you to use pre-tax dollars to pay for – what else? – dependent care. In order to take advantage of this account, you and your spouse (if applicable) must work, and the funds can only be used to pay for dependent care expenses while you are working.
- Transportation Savings Account: A transportation savings account is a benefit offered by many employers that allows you to use your pre-tax dollars to pay for qualified transportation expenses, such as parking (near your place of work or commute site, not near your home), public transportation, and vanpooling.