Are You Helping To Maximize Your Tax-exempt Bucket?

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. The more legal places we can find for our money, the more we can help prevent the government from taking too large a cut.

Mastering this 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 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, like cash value life insurance, that don’t get taxed at all and can be used for everything in between, like buying a second home, starting a business, putting 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 helping to maximize that all-important tax-exempt bucket. Most people find they aren’t, which means they’re giving away more of their income than they need to. So, if you’re one of them, here are several ways to start boosting your tax-exempt funds.

Backdoor Roth

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

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 something 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, the 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 take unlimited contributions, and, unlike 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.

There are a few other ways to invest in tax-exempt funds, including purchasing municipal bonds, which offer a powerful tax exemption. However, these also bring a credit risk, so they should be approached more cautiously than other options, ideally following advice from a financial advisor.

Whatever route you decide to take, the key is to help ensure you keep trying to maximize 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 term, medium term, and long term.