tax planning

Are You Maximizing Your Tax-Exempt Bucket?

Remember the child’s game hide-and- seek? As adults, most of us are still playing it. The difference is this time it’s with the IRS.

Paying state and federal taxes is part of life. Yet, of course, we all want to keep hold of as much of our income as possible too. That’s where what I like to call the grown-up version of hide-and-seek comes in. The more legal “hiding places” we can find for our money, the more we can stop the government from taking too large a cut.

However, rather than asking tax officials to close their eyes and count to 10, winning this particular game relies on having a tax-efficient financial plan. And that first means separating your finances into these three buckets:

  1. Taxable: Income like a salary or dividends on which we immediately pay tax and that’s designed to cover our short-term liquidity needs.
  2. Tax-deferred: Money in, say, a retirement plan or 401(k) that’s taxed when we use it and will fund us from retirement through death.
  3. Tax-exempt: Investments such as cash value life insurance that don’t get taxed at all and can be used for everything in between, like buying a holiday home, starting a business, putting the kids through college, or supplementing our retirement funds.

The advantage of this approach is that it shows you exactly where your money currently sits and, crucially, whether you’re maximizing that all-important tax-exempt bucket. Spoiler alert: Most people find they aren’t, which means they’re giving away more of their income than they need to – be it now or in the future. So, if you’re one of them, here are four ways to start boosting your tax-exempt funds today.

The backdoor Roth

With a backdoor Roth, you contribute to a non-deductible IRA and then sweep the money from there into a tax-exempt Roth IRA. You can do this up to the annual IRA contribution limit, which is currently $6,000 ($7,000 if you’re age 50 or over). Note, though, that this works best if you only have a single IRA. Otherwise, it can become very complex and cumbersome to track your cost basis across multiple IRAs in the long-term.

The mega backdoor Roth

If you’re in a position to save more than the annual IRA contribution cap, the mega backdoor Roth could be the way to go, if your plan offers it. Here, you take the non-deductible investment limit on your retirement plan — such as a 401(k) — and, if it’s more than $6,000 ($7,000 if you’re aged 50 or over), you invest it in your plan before moving it straight into your Roth IRA. That way, you benefit from a larger tax-exempt contribution. In order for this strategy to work, your 401(k) plan must allow after-tax contributions and in-service distributions of after-tax funds.

Health savings account (HSA)

In 2022 you can invest up to $3,650 as an individual to your HSA without paying tax on that contribution. As a family, you can add up to $7,300, and there’s also a $1,000 catch-up at age 50 and older. If you use the money to pay for anything that the IRS deems a qualified medical expense before the age of 65, you won’t pay tax when you spend it. Then at age 65, that limitation goes away and you’re free to spend the money on anything. All without ever being taxed on it.

Cash value life insurance

The amount you invest in a cash value life insurance policy accumulates on a tax-deferred basis, with tax only payable on any financial gains when the policy comes to an end. In the meantime, you can make unlimited contributions and, unlike with a Roth IRA, there are no financial penalties for early withdrawals. This means you can essentially borrow from yourself to pay major expenses or solve liquidity issues – something many business owners did during the 2008 financial crisis and, more recently, the pandemic. As long as the policy is in-force, you won’t pay tax on that “loan.”

There are a few other ways to invest in tax-exempt funds, including purchasing municipal bonds, which offer a powerful tax exemption. For example, if Georgia residents buy Georgia municipal bonds, they would not pay federal or state income tax on the yield. However, these also bring a credit risk, so they should be approached more cautiously than the other options, ideally following advice from a qualified financial adviser.

Whatever route you decide to take, the key is to ensure you keep on maximizing your tax-exempt bucket while balancing it with your taxable and tax-deferred funds too. That way, you can maintain a financial plan that matches your spending expectations in the short-, medium- and long-term. Time to hone those hide-and-seek skills!

About the Author

Stephen B. Dunbar III, JD, CLU

Director of Diversity & Inclusion, Executive VP, Equitable Advisors

Stephen Dunbar, Executive VP of Equitable, has built a thriving financial services practice where he empowers others to make informed decisions and take charge of their future. He and his team advise on over $3B in AUM and $1.5B in protection coverage. As a National Director of DEI for Equitable, Stephen acts as a change agent for the organization, creating a culture of diversity and inclusion. He earned a bachelor's in Finance from Rutgers and a J.D. from Stanford.

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