We’ve all heard about the fancy tax loopholes exploited by the ultra-wealthy – things like setting up offshore trusts in the Cayman Islands or taking advantage of arcane sections of the tax code. Teams of elite lawyers are constantly searching for new and creative ways for their moneyed clients to legally minimize their tax burdens. Exciting, right?
But where does that leave the rest of us?
While perhaps not as exciting as tropical tax havens, there are all sorts of legitimate “loopholes” that ordinary Americans can utilize to keep more of their income. But for the average person, taking full advantage requires a level of research and planning that most of us simply aren’t willing to commit to. Plus, government jargon (like “qualified distributions” and “tax deductible”) isn’t exactly fun to read.
So while the opportunities to legally reduce your tax burden are out there, most people leave money on the table because fully exploiting the system requires more effort than they’re willing to expend. Which is a shame, because the savings from maximizing things like retirement accounts and healthcare tax incentives could mean tens of thousands of dollars over a lifetime.
The Purpose Behind These “Loopholes”
At its core, the government is trying to influence behavior inline with certain policy priorities and objectives. When people are able to cover their own big-ticket costs, there is less strain on government safety net programs and less demand for public assistance. An aging population that has diligently saved for retirement is less reliant on Social Security. Families that have invested in 529 college savings plans ask for fewer student loans and grants. The more we can pay our own way through life’s major milestones, the less burden falls on the public purse.
Essentially, Uncle Sam is making you an offer – if you’re willing to lock up some of your income now and use it for a specific future purpose like retirement, you won’t have to pay taxes on it today. You only pay taxes when you finally withdraw the money decades down the road, or, in certain cases, you never pay taxes on it.
This concept of delayed taxation to encourage saving for the future is what drives programs across retirement, healthcare, education, and other key areas.
A Win-Win
Once all of these “loopholes” are laid out together, clear patterns emerge. The government has created a system of accounts specifically designed to incentivize saving and investing for major life expenses and goals like retirement, healthcare, and education.
These tax breaks can be quite substantial after factoring in taxes (federal income tax, state / local tax, and FICA). For example, a person in the lowest tax bracket can expect to save over 20%, their “marginal tax rate”, on every extra dollar they sock away into many of these special savings accounts. As income level goes up, this marginal tax rate can go as high as 50%.
Essentially, depending on your tax bracket, you can get anywhere from 20% to 50% off everything you buy in certain designated categories, so long as you are willing to use these special accounts.
Need to pay for your new contact lens prescription? Use a healthcare savings account. Need childcare, which can cost hundreds of dollars a month? Use a dependent care savings account and save hundreds more. Saving for retirement? Stick it into a retirement account instead of your brokerage and grow it tax-free. You get the picture.
The core principle is straightforward – shunt your money into these special, tax-advantaged accounts, and you’ll keep more of your money for things you’ll inevitably need to purchase anyway.
Special “Savings Accounts”
With this motivation in mind, it’s easy to understand why the government lays out so many ways for us to build our nest eggs. Below are the major categories the government wants you to save for, and how you can maximize your money by opening special accounts for each:
Category
Special Savings Accounts
Retirement:
- 401(k) – reduce taxable income now, but pay income tax when withdrawing in retirement
- Roth 401(k) – contributions are after-tax, but withdrawals in retirement are tax-free
- Traditional IRA – similar to 401(k), but with income limits
- Roth IRA – similar to Roth 401(k), but with income limits
- Self-Employed Retirement Plans (SEP, Solo 401(k)) – reduce a high amount of taxable income for those who are self-employed
Healthcare:
- Health Savings Account (HSA) – no taxes if used for medical costs
- Flexible Spending Account (FSA) – no taxes if used for medical costs (expires at end of each year)
Education:
- 529 Plans – no taxes if used for higher education costs
- Coverdell ESA – similar to 529, but with income limits; covers K-12 costs as well
Care-Related:
- Dependent Care FSA – no taxes if used for childcare costs (expires at end of each year)
- 529 ABLE – no taxes if used for for disability-related costs