5 Ways to Build Tax-Free Wealth
When a person frequently writes about tax-advantaged investing, as I do, he or she is likely to quote Benjamin Franklin from time to time, who said “In this world, nothing is certain except death and taxes.”
Instead of debating the merits of Mr. Franklin’s famous quote, in this post, I’ll just point out that, for the most part, taxes are challenging to avoid altogether.
This is especially true as your net worth increases.
And even though there are indeed a couple of ways to avoid taxes completely (which I will discuss below), there are numerous avenues Uncle Sam provides for significantly limiting the impact of taxes, especially when it comes to saving and investing for retirement.
Here are my five favorite ways to invest that will allow you to either avoid or reduce the impact of taxes as you build wealth.
Bear in mind, this is my “favorites” list. It is not necessarily an order of the most tax-efficient ways to invest.
1) Health Savings Accounts
Health Savings Accounts are the only investment account that I am aware of that offers the potential for completely tax-free contributions, earnings, and withdrawals.
Here is a quick list of HSA characteristics to keep in mind. For a thorough explanation and more details than you can shake a stick at, please read my post: What is an HSA?
- You must be enrolled in a High-Deductible Health Plan (HDHP) in order to contribute to an HSA.
- Contribution limits in 2025 are $4,300 for individuals and $8,550 for families.
- HSA’s can be opened through an employer-sponsored plan or through a variety of private providers.
- If you make contributions to an HSA directly through payroll deduction, you won’t have to pay Social Security of Medicare tax on your contributions either. That could save you another 7.65% in taxes.
- HSA withdrawals must be made for medical expenses only up until age 65 or you’ll owe income taxes and a 20% penalty.
- Once you turn 65, withdrawals can be made for any reason, but you will owe income tax if the money isn’t used for a qualified medical expense. In this way, HSAs work like a tax-deferred retirement account.
The major limitation of the tax-free benefits of HSAs is that the withdrawals only qualify if the money is used for a qualified medical expense (as defined by the IRS).
It’s a bit surprising to me that this turns so many people away from HSAs. After all, Fidelity estimates that the average couple will spend $330,000 on medical expenses in retirement in today’s dollars.
Even if you’re single or won’t retire for some time, there’s potential for huge tax savings through an HSA.
And even if you don’t use it all for medical expenses, beginning at age 65, you can treat it just like your IRA or 401(k) if you like. You won’t be any worse off from a tax standpoint.
One final caveat about HSAs: They do not make a very good inheritance.
Your spouse can use an HSA as their own after you pass away, but anyone else will owe income taxes on the entire balance of the inherited HSA in the year it is received.
For this reason, I recommend either using all of the money in your HSA before you die, leaving it to an heir who is in a very low tax bracket, or, if you have charitable intentions for your estate, leaving your HSA to a charity that won’t owe any taxes on the balance.
2) Taxable Brokerage Accounts
Taxable brokerage accounts may seem like an odd fit at number two on my list and, depending on your circumstances, that may be a valid concern.
I’ll start by pointing out that taxable brokerage accounts do not offer any tax benefits in terms of contributions. Barring some special circumstances, all contributions to taxable brokerage accounts will be made with after-tax dollars.
However, long-term capital gains (from appreciated assets owned longer than one year) are taxed at capital gains tax rates which are lower than income within the same brackets.
The same is true for qualified dividends.
The more impressive benefit of taxable brokerage accounts comes through thoughtful estate planning.
Any appreciated assets left to your heirs will receive a free step up in the tax basis, meaning those assets can grow and transfer to your heirs without ever being taxed.
In other words, if you have significant wealth, such that you have money you probably won’t use in your lifetime, and you want to transfer a large portion of that to your heirs, owning appreciated assets in a taxable brokerage account is an easy way to invest, grow, and transfer that money tax free.
Of course, this is true with nearly any appreciated asset (one of which I’ll discuss more next), but assets within a brokerage account are easy to own, grow, and direct to descendants, without much red tape or legal headache for your heirs after you pass.
3) Home Ownership
Speaking of assets that can be transferred to the beneficiaries of your estate with a free step-up in tax basis, your home can be left to your heirs without any tax implications, assuming the total value of your estate is below the federal lifetime exemption (estate tax).
Not only that, a home is one of the few investments that you can use while it appreciates in value. Most use assets don’t have that characteristic.
As a result, your net worth can grow as your home’s value increases and provide another handy way to limit taxes to your heirs.
I want to point out one key thing to bear in mind as you make legacy plans for your home.
Many people seek to spare their heirs the headaches of probate by adding them to the deed on their homes before they die.
If you do this, it will void the free step up in tax basis, not to mention expose your home to unnecessary risk if the co-owner was sued or faced some other sort of lien.
Instead of adding heirs to your deed, use a life estate deed or set up a trust instead.
4) Roth…Anything
If you’ve been on my website much or watched any of my YouTube videos, then you know I’m a huge fan of Roth accounts.
Roth’s are available through IRAs, 401(k)s, 403(b)s, 457s, and TSPs.
The federal government does not provide any tax incentives or deferrals for contributions through a Roth account, but all of the earnings and growth in a Roth account are completely tax-free.
So, while contributions to a Roth may not receive any special treatment, a Roth is one of the only paths to permanently excusing the IRS from any future claim on your money (legal trouble aside).
And that’s the primary reason I love the Roth. Harkening back to Ben Franklin’s point, Roths may not be totally tax-free, but at least they liberate you from the cloud of future tax liability.
Another feature I love about Roths is that they also eliminate future tax risks that could appear from changes in tax policy, Required Minimum Distributions (RMDs), or taxes for your heirs.
And since I’ve been bringing up estate planning often, I’ll add that Roth accounts are the best way to receive an inheritance because 1) they come with no tax liability for your heirs, and 2) the beneficiaries of your account can allow the assets to sit and grow for up to another 10 years before they have to liquidate all of the assets in the inherited account.
Effectively, inheriting a Roth is like getting access to an additional Roth account for 10 years. It’s a significant benefit.
5) Tax-Deferred Investing
Tax-deferred retirement accounts like IRAs, 401(k)s, etc. also provide great tax-saving benefits.
They are the tax reciprocal of Roth Accounts in that contributions are tax-free or tax-deductible, but all withdrawals are subject to income tax.
If you’re not familiar with these accounts, you might wonder if there’s any real benefit to using one if all the money coming out is taxed.
Well, by allowing your contributions to grow unhindered by taxes, the federal government is allowing more of your money to work for you to boost the amount of money you earn.
For example, let’s assume you have $1,000 pretax that you want to invest for 10 years leading up to your retirement, expecting an annual return of 8%. You are in the 22% tax bracket and you will be in that same bracket when you retire.
If you use a tax-deferred account, you’ll get to invest the full $1,000 which will grow to $2,158.92. After you pay 22% on your withdrawal, you’ll be left with $1,683.96.
If you used a taxable brokerage account, you’d only get to invest $780 after taxes, which would grow to the same $1,683.96. However, you now owe 15% capital gains tax on the earnings portion ($903.96) which was $135.59, leaving you with a net total of $1,548.37.
In other words, tax-deferred investing will spare you the effects of capital gains taxes.
This was a small example, but if you have ambitions to save hundreds of thousands or even millions of dollars, it’s not hard to imagine how the impact could grow significantly.
Tax-deferred accounts have come in at number five on this list, but that does not mean they should be ignored.
One final note on tax-deferred accounts; like Roth’s your heirs will have 10 years to liquidate the account (subject to RMDs), but all distributions will be taxed at their income tax rate.
This means there be limited estate planning tax benefits associated with tax-deferred accounts.
Wrap Up
Again, this list was primarily meant to stir thought as opposed to being a suggestion on how you should invest. Your own investing strategy is dependent upon your own goals and situation.
If you want to learn more about tax-advantaged investing, I have several playlists that I’ve linked below. You can also check out martinmoney.com for more information.
Thank you so much for reading. God Bless and take care!
