The very term “tax loophole” sounds like something illegal or something that only the wealthy can exploit. But there are various provisions in the IRS code that nearly anyone can take advantage of but that many Americans overlook.
They may feel like “loopholes” because they allow you to not only save on your taxes but also grow your money and/or improve your financial standing. Here’s a look at five ways you can legally use the tax code to make your money work for you.
Build Your Nest Egg: Tax-Advantaged Retirement Account
One of the biggest gifts of the U.S. Tax Code — for multiple reasons — is the deductibility of contributions to retirement accounts like 401(k) plans and IRAs. For starters, you generally won’t have to pay taxes on the money you put into these plans. That’s a tax savings that can reach close to 50% if you’re in the highest tax brackets.
Then, your money grows tax deferred — or even tax free, in the case of a Roth IRA — until you withdraw it. Essentially, the government is paying you to do something that’s in your own best interest — saving and investing for your retirement. As such, it’s one of the best “loopholes” that you can get.
Get Paid To Save: The Saver’s Credit
As if the tax benefits of contributing to a retirement plan weren’t enough, there’s an additional credit that you might be able to take advantage of on top of these other benefits. The Saver’s Credit, formally known as the Retirement Savings Contribution Credit, is worth 10%, 20% or 50% of the amount you contribute to the following types of plans:
- Contributions you make to a traditional or Roth IRA
- Elective salary deferral contributions to a 401(k), 403(b), governmental 457(b), SARSEP or SIMPLE plan
- Voluntary after-tax employee contributions made to a qualified retirement plan (including the federal Thrift Savings Plan) or 403(b) plan
- Contributions to a 501(c)(18)(D) plan
- Contributions made to an ABLE account for which you are the designated beneficiary.
Note that this credit does not apply to everyone. There are adjusted gross income limits based on your filing status. For example, if you are married and filing jointly, you’ll get a 50% credit with an AGI of no more than $43,500, a 20% credit with an AGI of $43,501 to $47,500, a 10% credit at $47,501 to $73,000 and a 0% credit with an AGI over $73,000. Different limits apply for other types of filers.
Invest in Yourself (or Your Kids): The American Opportunity Credit or Lifetime Learning Credit
One of the things the U.S. government is good at is incentivizing people to “do the right thing.” The credits and deductions that apply to retirement contributions, for example, are a great way to encourage people to save.
Educational credits like the American Opportunity Credit and the Lifetime Learning Credit are ways that the government encourages Americans to get an education. Although you can claim both credits on your return, you can’t use them for the same student or the same expenses. The credits are somewhat similar but have some important differences.
For the American Opportunity Credit, you can get back 100% of the first $2,000 you paid in qualifying educational expenses for each eligible student and 25% of the next $2,000 you spent for that student.
With the Lifetime Learning Credit, you can claim up to 20% of the first $10,000 you pay in qualifying educational expenses.
Both types of credits have modified adjusted gross income limits of between $90,000 and $180,000, depending on filing status. Credits are phased out as these limits are approached. Various other restrictions and limitations apply.
Take Advantage While You Still Can: The Backdoor Roth IRA
The so-called “backdoor” Roth IRA has been on the chopping block for years in Washington, but legislation eliminating it has yet to be passed. This makes the backdoor Roth IRA a true loophole that is likely to vanish at some point.
The backdoor Roth IRA isn’t a specific account as much as a strategy for higher-earning taxpayers, who aren’t allowed to contribute to a Roth IRA. By contributing instead to a traditional IRA and then converting that amount to a Roth IRA, you can still end up with money in your Roth IRA, even though it is supposedly not allowed. This makes this “backdoor” method a true loophole.
Save Money by ‘Prepaying’ Your Health Expenses: Fund an HSA
If you have a high-deductible health insurance plan — defined as $1,400 for a single person or $2,800 for a family — you can qualify for a health savings account. These accounts can be triple tax free, making them excellent options for saving money on taxes and putting it to work on your behalf.
Qualifying contributions to an HSA are tax deductible, earnings grow tax free, and distributions are tax free if used for eligible health expenses. Non-eligible withdrawals face regular taxation and a steep 20% penalty, but when used properly, an HSA is a great account to have.
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