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Tax shelters for the middle class

I know, "tax shelters" is a bit of a loaded word, bringing to mind Swiss bank accounts and offshore holdings in the Cayman islands. When I use the term, though, I'm specifically referring to an optimization problem: where to put your taxable long-term investments such that you have the right balance of flexibility and tax savings.

And this problem comes up with tech professionals a lot. (a) They tend to be well compensated, (b) they're generally not interested in keeping up with the Joneses, and (c) they have a high "pain of paying", so they tend to naturally accumulate savings. Combine this with (d) analysis paralysis and (e) busy lives, and they end up with rather large balances in their savings accounts before coming to a financial planner!

So: here are some of the strategies we most often discuss for "tax sheltering" those assets.

(Roth) Individual Retirement Accounts

You've probably at least heard of these, and if you're like many tech professionals who've been in the industry for a while, you've dismissed them from your mind because you exceed the income limits. Well, it turns out that this doesn't necessarily keep you from Roths entirely; you just have to take a roundabout path known as a backdoor Roth IRA.

Roth IRA's are excellent tax-sheltered savings vehicles from a flexibility standpoint, because even though they grow tax-free, you can access your contributions (but not earnings) tax- and penalty-free at any time, even before retirement! This makes for a nice "freebie" -- given how easily accessible your contributions are, why not put your investments there?

They're quite straightforward to contribute to, as well: each year, you simply withdraw the desired funds from your taxable account and contribute them to the Roth IRA.

Of course, backdoor Roth IRA's make things slightly more complicated, in several ways:

  • Setting your finances up to enable them (i.e. rolling your Traditional IRA's into your 401(k)'s) is...not fun. But once it's done, it's done.

  • The annual contributions require an extra step, as you actually make a non-deductible contribution to a Traditional IRA and then convert to your Roth. However, the extra step is generally pretty painless.

  • Because of this extra step, however, the contributions are technically conversions, which means that you have to wait five years before accessing a given contribution. So this does limit your flexibility somewhat, especially during the first few years after you start.

Hopefully you've gotten the impression by now that backdoor Roth IRA's, while a nice feature of the tax code, are easy to screw up. Proceed with caution and/or expert help!

Health Savings Accounts

I consider HSA's (not to be confused with FSA's) to be neck-and-neck with Roth IRA's in terms of being Generally Great Tax Shelters.

On the tax-advantage side, they're clearly better than Roth IRA's, as they provide both a tax deduction and tax-free growth! Yes, this is only if they're used for qualified medical expenses, but once you hit retirement age, you can treat them like Traditional IRA's if necessary. However, you can't contribute as much per year: the per-person max contribution is currently $3500, while the Roth max is $6K -- $7K if you're 50 or older!

On the flexibility side, they're not quite as good, as you can only make withdrawals for qualified health expenses (until 65, per above). Still, given that medical expenses are often one of the biggest emergency expenses -- especially under a high-deductible healthcare plan -- this is a very useful point of flexibility!

Finally, it can be somewhat annoying to effectively move assets from a taxable account into an HSA. Because contributions are withheld from your paycheck, you can't just transfer the money from your taxable account to your HSA. Rather, you could adjust your HSA withholding and then set up a withdrawal from your taxable account into your checking account, in order to make up the difference in your effective take-home pay. You could spread this out over the year, or max out your HSA in your first paycheck, make a one-time transfer from your taxable account to checking, and then set your HSA contributions to zero for the rest of the year -- whichever is less annoying to you.

Qualified Retirement Plans

On the subject of pre-tax deductions, QRP's (401(k)'s, 403(b)'s, and the like) can also make for decent tax shelters.

Depending on whether the contributions are Traditional or Roth, you get either tax-deferred or tax-free growth, which is certainly the aim of the game.

However, where flexibility is concerned, your options for pre-retirement withdrawals are more limited, though they do exist -- 401(k) loans, for example. So be careful before locking up your assets in a QRP; sometimes flexibility is worth the tax!

That said, do be aware that if you roll your Roth 401(k) funds over into your Roth IRA, you can then access the contributions at any time under the standard Roth IRA rules. Useful for when you change employers! (Of course, if you want to make backdoor Roth IRA contributions, you'll need to roll your Traditional 401(k) funds into your current 401(k).)

And as with HSA's, you can't just move money directly from your taxable account to your 401(k); instead, you have to increase your pre-tax deduction, then supplement your take-home pay from your taxable account. However, also like HSA's, you spread this over the year or do it all in one shot, hitting the max contribution at the beginning of the year and then reducing your contribution to zero.

529 plans

If you're saving for college, 529 plans are the classic tax shelter, allowing for tax-free growth -- but, like HSA's, only if used for qualified educational expenses.

So again, flexibility takes a hit, and unlike HSA's, there's no "get out of jail at retirement age" card -- though 529's are eminently transferable between family members. And given how variable (or non-extant) college expenses can be, it's worth considering your other options carefully before funding your 529.

On the other hand, they're super-simple to fund. And there's no income limit and generally no contribution limit, other than the gift tax exclusion, which may or may not actually matter to you.

And Now You Know

They're no Swiss bank accounts, but why go to the trouble if you don't have to? And if you've already got non-sheltered assets and are looking to minimize the tax burden of selling them, here's an article you may want to check out, as well.

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.

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