As a self-employed individual, it's easy to fall into the trap of prioritizing bills and purchases over personal income. However, many taxpayers may not be aware that embracing the 'pay yourself first' strategy can lead to substantial tax savings and foster frugality. By saving or investing your income before tackling monthly expenses or making purchases, and utilizing tax-advantaged savings vehicles such as HSAs, IRAs, 529 Plans, and life insurance retirement policies, you can maximize both tax savings and income over time.
The 'pay yourself first' approach emphasizes setting savings goals and using income to achieve them before addressing expenses. This way, your spending habits are structured around your savings objectives.
Invest in a Child IRA – Reduce your Tax Bill
Paying yourself first can extend to using your income to set up a Child IRA for your children, an excellent strategy to maximize tax savings over time. This approach offers your children tax-free income during their retirement years. The sum of contributions, dividends, and interest accumulated over decades becomes available to your children tax-free, saving them a considerable amount.
For parents who are self-employed in specific industries, employing your children can bring additional benefits. Your children's wages can be deducted from your business's income while they save for retirement. Moreover, if your children are under 18, you won't have to pay Social Security or Medicare taxes on their income. By transferring some of the business income to your child's tax bracket, you can benefit from a lower tax rate, resulting in significant tax savings.
Invest in a Roth IRA – Reduce your Tax Bill
Adopting the "pay yourself first" mindset and channeling that income into a Roth IRA is an excellent method for boosting your earnings and enjoying tax savings. By contributing after-tax dollars to a Roth IRA, your funds grow tax-free. Once you reach 59.5 years of age and have maintained the account for at least five years, you can withdraw money tax-free.
The Roth IRA stands out as a more flexible account compared to others, as it can be held indefinitely without any required minimum distributions. This long-term investment strategy ensures financial security and significant tax savings for your future.
Contribute to an HSA – Reduce your Tax Bill
Absolutely! Health savings accounts (HSAs) offer a triple-tax advantage when established using the pay yourself first strategy. Contributions to HSAs are 100% tax deductible, reducing your gross income. If HSA withdrawals are used for qualified medical expenses, any interest earned remains 100% tax-deferred, meaning that growth is not subject to taxes. To fully benefit from this tax advantage, it's essential to adhere to the annual contribution limits set by the IRS each year.
Save for Education – Reduce your Tax Bill
A Section 529 Plan, commonly known as a "529 Plan," is an effective strategy when prioritizing paying yourself first. This tax-advantaged savings plan is designed to help cover education expenses. There are two types of 529 Plans: Prepaid Tuition Plans and Education Savings Plans.
Prepaid Tuition Plans enable parents, grandparents, and others to prepay tuition fees at today's rates for eligible public and private colleges or universities, effectively managing future tuition costs. One significant advantage of this plan is that it locks in the current tuition rate for future attendance at designated institutions, potentially resulting in substantial savings as college costs continue to rise annually.
Education Savings Plans, on the other hand, allow account holders to open an investment account to save for the beneficiary's qualified higher education expenses or tuition for elementary or secondary public, private, or religious schools. Like other strategies mentioned, education savings grow tax-deferred, and withdrawals are tax-free if they are used for eligible educational expenses.
Opening a 529 Savings Plan
Setting up a 529 plan is a straightforward process. You can purchase these plans from the state, a broker, or a financial advisor. Keep in mind that rules and fees vary by state.
Usually, a parent or grandparent opens a plan on behalf of a child, who becomes the account's beneficiary. In some states, this may even qualify for a state tax deduction. However, it's worth noting that anyone can open a 529 account.
The 529 plan is a custodial account, meaning the beneficiary does not control the funds – the custodian manages the assets on behalf of the minor. Once the beneficiary turns 18, they can assume control over the account, though funds must still be used for eligible education expenses.
You can typically open accounts online and set up direct deposits into the account. Some plans may require a minimum deposit to open the account, and fees can include annual fees, management fees, and account opening fees.
To open an account, you'll need the social security number or tax ID, date of birth, and address for both the custodian and beneficiary. You can then employ various investment strategies to grow your Section 529 portfolio.
Pay Yourself First
By adopting the pay yourself first strategy, you ensure that you have funds readily available to save and invest, leading to tax savings in the long run. If you prioritize expenses and purchases before setting aside money for investment opportunities, you may miss out on the potential financial benefits that these investments can offer.
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The material discussed on this page is meant for general illustration and/or informational purposes only and is not to be construed as investment, tax, or legal advice. You must exercise your own independent professional judgment, recognizing that advice should not be based on unreasonable factual or legal assumptions or unreasonably rely upon representations of the client or others. Further, any advice you provide in connection with tax return preparation must comply in full with the requirements of IRS Circular 230.