Money you place in traditional savings accounts is already taxed by both the Federal and State governments. These after-tax deposits lower the amount you have available for savings. Lower deposit amounts also mean lower earnings potential. Then Interest earned on your savings is also taxed. What can you do to lessen this tax burden?
1. Leverage tax-advantaged retirement accounts. Use 401(k), 401(b) and similar programs to deposit pre-tax money into retirement accounts. This way your initial deposits are larger because they have not yet been subject to income tax. This will provide higher earnings on your savings because of the pre-tax contributions. The downside? Your benefits and contributions will be taxed when you withdraw the funds.
2. After-tax savings deposits – no tax on earnings. There are a number of options that eliminate the extra tax on earnings within your savings accounts. The most common are Roth IRAs, Coverdell ESAs, and 529 College Savings Plans. As long as you follow the rules, your earnings within these accounts won’t be subject to additional taxation.
3. Shift the savings. Use gifts to shift the savings balances to someone with a lower tax rate. Earnings in a child’s savings account are taxed at a lower rate than most parents’ tax rate as long as the earnings are below kiddie tax thresholds ($2,000 in 2014).
4. U.S. Savings Bonds. Interest income on some U.S. Savings Bonds are deferred until the bonds are redeemed. In addition, the Saving Bond interest can be omitted if the proceeds are used for qualifying educational expense.
5. Municipal Bonds. While Municipal Bonds have fallen out of favor recently, they are another means of making earnings on savings more tax efficient. Most municipal bonds earnings are federal tax-free. It may also be free from state taxation if the bond is from your state of residence. This tax-free status applies to earnings only. Remember, bonds might also be subject to capital gains tax and ordinary income tax based on values when they are bought or sold.
While there are numerous alternatives to make your savings more tax-efficient, do not overlook the changing landscape of interest rates. Most financial experts believe interest rates will once again pick up as the economy strengthens.