Pay Yourself First: The Road to Tax Savings

If you’re self-employed, it’s tempting to put your money toward bills and purchases first then pay yourself out of the remainder. Many taxpayers don’t realize that paying yourself first is a great strategy for saving money and promoting frugality. You may be surprised to learn that you can maximize tax savings and income over time by saving or investing your income prior to paying monthly expenses or making purchases and by taking advantage of tax preferred savings such as HSAs, IRAs, 529 Plans, and life insurance retirement policies.

The ‘pay yourself first’ strategy emphasizes using income as a goal towards savings before expenses. Your spending is built around your savings goals.

Why Does Investing Your Income First in a Child IRA Save Money on Taxes Down the Road?

Paying yourself first can include using that money to set up an IRA for your child(ren) is a great way to maximize tax savings over a period of time. This provides your child(ren) with tax-free income during retirement. Decades of contributions, dividends, and interest added up throughout the years are available to your child(ren) tax-free, saving them tens of thousands of dollars.

Parents who are self-employed in certain businesses can hire their child(ren) as an employee. The child’s wages can then be deducted from the business’s income while the child is putting money away for retirement.

Furthermore, if they are younger than 18, the parent won’t have to pay social security or Medicare tax on the child’s income. The parent can then shift some of the business income over to the child’s bracket and take advantage of a lower tax rate. This results in substantial tax savings.

How Does Paying Yourself First and Investing in a Roth IRA Pave the Way to Tax Savings?

Paying yourself first and putting that income into a Roth IRA is another great strategy for maximizing your income and saving on taxes. By contributing after-tax dollars to a Roth IRA, your money grows tax-free. Once you have reached the age of 59.5, money can be withdrawn tax-free so long as the account has been open for at least five years. The Roth IRA is a less restrictive account compared to other accounts that can be held indefinitely with no required minimum distributions.

Does an HSA Established With the Pay Yourself First Strategy Save on Taxes?

Yes, yes, and yes. Health savings accounts (HSAs) are triple-taxed advantaged. Contributions are 100% tax deductible and are deducted from your gross income. As long as withdrawals from an HSA are for qualified medical expenses, any interest earned is 100% tax-deferred which means that any growth is not subject to any taxes. To receive the full tax-advantage, you must remain within the annual contribution limit that the IRS sets each year.

Is a Life Insurance Retirement Policy an Effective Strategy in Investing Your Income First to Save on Taxes Later?

A Section 529 Plan (typically just called a “529 Plan”) is another good strategy to use when you pay yourself first. It is a tax-advantaged savings plan that was created to help cover education costs. There are two types of 529 plans: the Prepaid Tuition Plan and the Education Savings Plan. Prepaid tuition plans allow parents, grandparents and others to prepay tuition at today’s tuition rates at eligible public and private colleges or universities, helping them manage future tuition costs. Another advantage to the Prepaid Tuition Plan is that it locks in the current rate of tuition for attendance in the future at designated universities and colleges. This can also be a huge savings since the cost of college continually rises every year. 

An Education Savings Plan lets an account owner open an investment account to save for the account beneficiary’s qualified higher education expenses or tuition for elementary or secondary public, private, or religious schools. Like some of these other strategies, education savings grows tax-deferred and all withdrawals are tax-free if used for eligible educational expenses.

How Can I Open a 529 Savings Plan?

Opening a 529 plan is a simple process. These plans can be purchased from the state, a broker, or financial advisor. The rules and fees differ by state.

Typically, a plan is opened by a parent or grandparent on behalf of a child. This person becomes the account’s beneficiary, and in some states, may even be eligible for a state tax deduction. However, it’s important to note that anyone can open a 529 account.

The 529 plan is considered a custodial account, which means the beneficiary does not control the account. The custodian controls the funds on behalf of the minor. Once the beneficiary reaches the age of 18, they can take control over the account. Funds from the plan must still be used for eligible education expenses.

Accounts can usually be opened online and funds can be directly deposited into the account. Some may require a minimum deposit to open the account. Fees may include annual fees, management fees, and account opening fees.

To open an account, you will need the social security number or tax ID, date of birth, and address for both the custodian and beneficiary. You can use a variety of investment strategies to grow your section 529 portfolio.

Getting the Most Out of the Pay Yourself First Strategy

By paying yourself first, you’re guaranteed to have money available to save and invest which will save on taxes over time. Otherwise, if the money goes towards expenses and purchases first, then you may not have the funds available to take advantage of these investment opportunities.

Corvee tax planning software will help you find ways to benefit the most by making your income a priority over expenses and by building your spending around your savings goal. Ensure you and your business are tax-advantaged. See how Corvee can help