Three Categories of Federally Chartered, Tax Favored Plans You Need to Know in Order to Build Wealth
Updated: Sep 19
SOME OF THE EASIEST WAYS FOR YOU TO BUILD WEALTH (These are no-brainers)
Tax-favored Retirement, Health, and Education Plans.
The most overlooked tool or strategy for individuals and small businesses to use in order to build wealth is to MAX-FUND all of the IRS tax-favored benefit plans for which you are eligible and are appropriate to your life and circumstances. Think of it like building a house and each plan type is another brick in the financial house you are building. As an example, the average family of employee spouses can take advantage of their respective 401(k) plans in addition to an HSA program and or some sort of flexible spending account for health and childcare, and a College Saving Account. This strategy could help them set aside over $170,000 per year tax-advantaged.
The IRS announced they are raising the maximum contribution limits significantly for deferrals and contributions in the tax year 2023 as I shared in my post earlier this week. I’ll summarize some of the most common limits at the end of this article.
If you are self-employed, you can fund an IRA, SIMPLE IRA, Individual 401K, or Defined Benefit Pension Plan depending on your circumstances. You can also create or enroll in health reimbursement plans HSA, FSA, HRA, etc. to layer on top of the retirement plan.
Benefit plans created by Federal law fall into three broad categories with multiple choices in each category. The three categories are (1) Retirement, (2) Health, and (3) Education. Some of the common plans available in each category are:
#1 - Retirement
401(a) Money Purchase Plans
401(k) the most common employee deferral plan
Profit Sharing Plans often attached to 401(k) plans
403(b) and 457 Plans for governmental and non-profit organizations
Defined Benefit Pension Plans
Individual Retirement Accounts, (IRA) and (Roth IRA)
Simplified Employee Pension (SEP)
SIMPLE IRA for small business
Individual 401(k) my favorite for small, closely held businesses.
#2 - Health
Health Savings Accounts (HSA)
Health Reimbursement Arrangements (HRA), IRC Section 105
Flexible Spending Accounts (FSA) IRC Section 213(d)
Cafeteria Plans, IRC Section 125(a) defined in (d)(1)
#3 - Education
529 College Savings Plans, IRC Section 529
Coverdell Education Savings Accounts, IRC Section 530
Some advisors recommend Uniform Gifts to Minors Act and Uniform Transfers to Minors Act (UGMA/UTMA), and Roth IRAs for education. These plans have their limitations and advantages.
You should work with your financial and or tax planner to identify which tools you are eligible to use and whether they are all expedient for your unique financial tax and employment situation. Once you identify the appropriate plans for you, your family, and your business—then fund them to the maximum you can afford. If you don’t have an advisor, feel free to reach out to me by DM or contact me at JimPalumbo.com .
Using this strategy is a no-brainer. For example, money in your Roth IRA or 401(k) has minimal restrictions, taxes, or penalties so it is therefore flexible enough to help you meet your needs in certain circumstances and life stages. Roth dollars are not hopelessly “locked-up” in such a way that you need to fear building a large balance in those accounts (I hear this a lot). Another example is the health and education accounts. In all practicality, your family will have somewhat predictable education, health, and childcare expenses each year or in certain forward years, so take some time to identify these expenses in advance. You can then fund these accounts with those expenses in view and ultimately pay the expenses with tax-favored dollars. If you don’t fund the plan, you still have to pay your annual health care or childcare costs but you are paying them with after-tax dollars. Health-related plans (in contrast to retirement and education plans) are tax-free rather than tax-deferred which is another advantage.
Here are the 2023 contribution limits for some of the most common plans as announced by the IRS:
IRA ROTH IRA - For 2023, the total contributions you make each year to all of your traditional IRAs and Roth IRAs can't be more than $6,500 ($7,500 if you're age 50 or older), or if less, your taxable compensation for the year
401(k), 403(b), SARSEP IRA – The limit for employee deferrals is $22,500 (up from $20,500 in 2022) plus $7,500 catch-up contribution for participants over age 50, and an additional $43,500 in employer contribution and forfeitures for a total limit of $66,000 (plus the $7,500 catch-up) brings the maximum for age 50+ savers to $73,500 for the tax year 2023.
SIMPLE 401(k) – Employee deferrals are limited to $15,500 for 2023 up from $14,000 in 2022.
529 College Saving Plan – No limit, but contributions are considered completed gifts for federal tax purposes. The first $17,000 are considered excluded from gift tax for 2023 (lifetime limit of $12.92 million per beneficiary).
Coverdell Education Savings Account – The limit remains $2,000 per child.
Health Savings Account (HSA) – The limit is $3,850 for self-coverage and $7,750 for family coverage plus an extra $1,000 for those 55 and older.
Health Reimbursement Arrangements (HRA) – Limits are $1,800 for 2023
Flexible Spending Accounts (FSA) – Employees can contribute $3,050 for 2023 (Use it or lose it, only 20% can roll over to the subsequent tax year).
You can layer these plans by taking advantage of more than one plan for your family. A simple example would be a family of four with both parents working and eligible for a 401(k), at their employer or in their small business, with maximum match and profit-sharing availability, a 529, and an HSA option. They can save a total of $171,500 into tax-favored accounts for 2023. That is not counting catch-up provisions but is considering a max-out on the retirement plan. The total goes up to $187,750 if mom and dad are over age 55. Not every family has nearly $200K in disposable income to fund these accounts, nonetheless, it is important to know where the goal post is and strive to make progress toward it as appropriate for your family. For high-income folks, you can take advantage of several solutions at once.
Obviously, there are numerous qualifiers and what-if scenarios to consider when putting together my MAX-FUND plan for individuals and families and you need to work through each exception or circumstance, however, my goal in this article is simply to remind savers and advisors that thoughtful research and planning can create above average results for a family by exploiting tax advantages but more importantly, creating a runway for systematic saving and accumulation in targeted, purpose-driven account stylings.
Aggressive savings rather than aggressive consumption during your working years is the fastest path to wealth.
Systematic Investing is another reason to consider aggressive, systematic funding of your bucket of wealth. You will minimize market risk from your investments if you are adding money to your accounts every month for the 40 years of your working career. If, of course, the lifetime funding of the account is systematic, and the portfolio is broadly diversified and appropriate to your goals, time horizon, and your family's Investment Policy (FIP) parameters, you can effectively and efficiently build wealth and reduce taxes. A bad investment policy will still lose all your money for you, even if you save systematically, so put some time into developing your FIP. (A Family Investment Policy is a document that your family drafts together and or in concert with your Investment Advisor Representative to make your goals, set guardrails as a family, and identify the behaviors to which the family members agree in order to reach the goals.)
For my financial advisor friends, this information may seem elementary, but I'm surprised by how many investors I meet who tell me their advisor has never shared any of this information with them. The advisor did not forget, however, to sell them life insurance and an annuity.
For trivia nerds—the numbers which identify the plans, 401(k), etc., are the code sections (like chapters) under Title 26 of the Federal tax code which contains nearly all of the federal tax laws. Your typical 401(k) is defined on the pages following 401(a) Money Purchase Plans. The laws governing and defining your IRA are found under Code Section 408(a), interestingly.
Be sure to talk to your advisor or you can reach out to me at JimPalumbo.com to evaluate your financial plan in light of this discussion. I love hearing from you. If this article was helpful, please click “LIKE”, or “SHARE” it, and give me some feedback in the comments.
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