It’s open enrollment season right now and I’m a little bit bummed. For the past few weeks, I’ve been getting text messages from my previous employer (which happens to be the State of Minnesota) reminding me to enroll in my workplace benefits for the coming year. Since I no longer work for the state, I obviously can’t take advantage of any of these benefits.
Working for the state had some pretty nice perks. Not only did I get a 6% match on my retirement accounts, but I was also able to utilize a High Deductible Health Plan (HDHP), which, in turn, gave me access to a Health Savings Account (HSA). The HSA, as many of us personal finance nerds know, is probably the ultimate secret retirement account for millennials. That’s because, in addition to giving us lower premiums at a point in our life when we’re probably using very little healthcare, the HSA also has the unique ability to offer us triple tax-advantaged savings.
For pretty much every tax-advantaged account, you’ll pay taxes at some point in your life.
- With tax-deferred accounts, you avoid paying taxes on your contributions now, but you’ll pay taxes on your contributions when you withdraw them.
- In contrast, with Roth accounts, you make contributions using your post-tax income but can then withdraw that money tax-free in the future.
The interesting thing though, is that there are accounts out there that let you put your money in tax-free, grow your contributions tax-free, and take your money out tax-free. These triple tax-advantaged accounts basically allow you to earn and grow your income without ever paying taxes on it.
Obviously, if we can earn and grow our income without ever paying taxes on it, we want to take advantage of that as much as we can.
With that in mind, let’s take a look at a few of the ways we can get triple tax-advantaged savings (i.e. tax-free contributions, tax-free growth, and tax-free withdrawals).
Use A Health Savings Accounts
The first and most obvious way to get triple tax-advantaged savings is by making use of an HSA.
For most millennials, taking advantage of an HSA is a no-brainer. You’re probably not a heavy user of healthcare at this point, so it makes sense to enroll in an HDHP, pay less in premiums each month, and gain access to an additional tax-advantaged retirement account. For myself, in the 4 years since I graduated law school, I’ve gone to the doctor a grand total of ONE time – and only because my wife made me go.
What makes the HSA so amazing though isn’t just the additional tax-advantaged space – it’s the fact that contributions to an HSA have the ability to be triple tax-advantaged. Your HSA contributions go in tax-free, grow tax-free, and can be withdrawn tax-free so long as they’re used for qualified health expenses (after age 65, any remaining contributions can be withdrawn and get taxed at your ordinary income rate, basically the same as any other tax-deferred account).
An HSA has the potential to add up to A LOT of potentially triple tax-advantaged money. Here are what the HSA contribution limits look like for 2017 and 2018:
- For 2017, max of $3,400 for individuals, $6,750 for families
- For 2018, max of $3,450 for individuals, $6,900 for families
Depending on whether you’re an individual or a family, those contributions can grow to somewhere between $300,000 and $700,000 in potentially triple tax-advantaged savings over a 30-year period.
I’ve written about HSAs before here and here, so I recommend checking these posts out if you’re looking for some more in-depth info on how HSAs work.
The main thing to take away from this is that if you’re young and in good health, you should probably take advantage of an HSA. The tax advantages are just way too good to pass up.
Fund A 529 Plan
Most people think of 529 plans as a way to get tax-free growth for future college expenses, but interestingly, 529 plans also provide a terrific vehicle to turn otherwise taxable income into triple tax-advantaged savings – at least with respect to state taxes.
Here’s how it works. Depending on where you live, your state might offer a state tax deduction for contributions made to a 529 plan. You’ll need to check your particular state law to determine if this is available to you and what the requirements are to qualify for the state tax deduction (I found this great calculator from Vanguard that provides a great starting point).
If you live in a state that offers a tax deduction for 529 plan contributions, that means that the deductible amount that you put into your 529 plan can become triple tax-advantaged – you can put money into your 529 plan and take it out without ever paying any state income taxes on that income.
The caveat, of course, is that your 529 funds have to be used for qualified education expenses. Still, assuming that you will have some educational expenses, the 529 plan makes a lot of sense.
What a lot of people often forget is that 529 plans don’t have to be for your children – you can use them for yourself too. If you’re a current student and paying tuition out of pocket, you should consider funneling your tuition payments through your 529 plan in order to turn that taxable income, into tax-free income (I wrote about this 529 plan hack in this post from earlier this year).
Take my home state of Minnesota as an example. The legislature here recently passed a law allowing single individuals to deduct up to $1,500 from state taxable income and up to $3,000 from state taxable income for married couples.
This works perfectly for a couple like my wife and I. She’s still a resident and her residency requires her to pay a fairly small amount of tuition – about $4,000 or so each semester. By funneling our tuition payments through her 529 plan, we can essentially turn $3,000 of her tuition payments into completely, tax-free income.
Take Advantage Of The Master’s Rule To Fund Your Roth IRA
The Master’s Rule is another option that can allow you to turn tax-free income into completely tax-free growth – in a way.
I’ve written about the Master’s Rule before, but as a quick recap, the IRS allows you to earn rental income completely tax-free so long as you rent out your property for 14 days or less in a calendar year.
If you take that tax-free income and fund some or all of your Roth IRA with it, you’ve essentially turned tax-free income into tax-free growth too. You’ve put in money that you paid no taxes on and you’ll be able to withdraw that money tax-free in the future too (of course, to do this, you’ll have to have some taxable income during the year).
For most homeowners, renting out a property for 14 days is doable. That’s just 2 or 3 days per month – which anyone can do using Airbnb. How much you can earn in that 14 days will really depend on how you choose to rent out your property.
If you’re like me, you probably have an empty guest room in your house, which means at minimum, you’ve got the ability to earn at least some tax-free rental income without having to really do anything beyond opening up a room in your house.
If you’re in a location that has desirable events, it’s possible for you to earn huge amounts in a very short period of time. Someone in Minneapolis this year could easily put up their home on Airbnb during the Superbowl, rent it out for a few thousand dollars over a weekend, and pocket all of that income, totally tax-free (people here did the same thing during the Ryder Cup in 2016). For some people, 14 days can be enough to fully fund a Roth IRA with tax-free income.
Do Roth Conversions In Low Earning Years
Roth Conversions are a way to take advantage of low earning years, potentially allowing you to turn tax-deferred contributions into tax-free growth and tax-free withdrawals.
In order to do this, you’ll have to convert your deductible IRA contributions in years where you’re earning essentially little to no income. I think three people really stand to take advantage of Roth Conversions:
- Folks who are hitting early retirement and have enough cash on hand to cover their lifestyle for five years, or
- Folks who are going back to school full-time and have money in an IRA that they can convert; or
- Folks doing a mini-retirement that will have a no-income year.
This will go beyond the subject of this post, but essentially a Roth Conversion works like this. You convert income from a deductible IRA to a Roth IRA. After five years, you can then withdraw that conversion, completely tax-free. Of course, you can also just leave that income in there, allow it to grow, and then withdraw it tax and penalty free after 65.
The conversion from an IRA to a Roth IRA is a taxable event itself – it counts as earned income for the year. But if you’ve got a low enough income for the year, either because you’ve saved that much in cash or you’re a student in a low-earning year, you’ll have an income for the year that’s low enough that you’ll owe no taxes anyway.
The main thing to take away from this post is that there are ways to turn taxable income into completely tax-free income. You just have to be willing to think creatively and use the tax-advantaged accounts that are available to you.
Most people, depending on where they live and what kind of work they do, will be able to take advantage of all of these methods of gaining triple tax-advantaged income. Even a few thousand dollars of triple-tax advantaged savings per year will add up to huge amounts of tax-free income in the future.
So, some things for you to do right now:
- If you haven’t already, check to see if enrolling in an HDHP makes sense for the upcoming year. If so, make sure to utilize the HSA as much as you can.
- Does your state offer a tax deduction for 529 plan contributions? If so, assuming the rest of your financial house is in order, take advantage of it.
- Any chance you’d consider doing Airbnb for 14 days or less in a year? Even if you hate people, I bet you can handle hosting someone for 2 or 3 days per month. Then, take those earnings and dump them into a Roth IRA.
- Check to see when you can strategically do Roth Conversions during very low-income years.
Any other ways of getting triple tax-advantaged savings that you are doing?
*Note, I’m definitely not a tax professional, so talk to your tax person first.
Dave @ Married with Money says
HSA is the biggest thing for me on this list. We’re definitely not in low-income years at the moment, have no foreseeable education expenses for the remainder of our lives, and while AirBNB sounds interesting we’re sadly part of an HOA which prohibits short-term rentals like that…so that’s off the table. Boo!
Still, an HSA is awesome and like you I basically never go to the doctor so our out-of-pocket expenses are extremely low.
Financial Panther says
Yeah, I’m bummed because my new job doesn’t have a HDHP, so I can’t get an HSA anymore. They do pay for my whole health insurance premium though, so I’m not paying anything for health insurance, which is at least a nice bonus.
A big one is the dependent care FSA for those with children. Payouts are tax free and then roll the cash into a Roth.
Financial Panther says
Oh nice! I didn’t know about this one. Will have to look this up and add to the list.
The Grounded Engineer says
I recently crunched the numbers to see of a lower deductible plan would be worth switching to during a year we plan to have our next child. The high-deductible, HSA plan is actually more cost effective. The key is to look at what the max-out-of pocket is. Now, most of a delivery for a new child is covered, but for us the epidural and a few other things weren’t covered. For my health plan, the HSA max out of pocket was less than the higher premium plan! So run the numbers!!
Financial Panther says
Good point about crunching the numbers!
Making Your Money Matter says
The other amazing thing about an HSA and a dependent care FSA is that if you contribute directly from your paycheck through your employer, it’s not subject to FICA taxes (Social Security and Medicare). That’s another 7.65% (of course high-income earners are already capped in their social security earnings anyway).
Taxes really make a huge difference in how much money you are keeping. Great post FP!
Financial Panther says
Right! As far as I know, HSA contributions directly from your paycheck are the only way to get around FICA taxes – so definitely worth taking advantage of that if you can.