Tax Free Investment Plans for Educators

Tax season often inspires people to think about their financial status and to explore financial investments for the future. Fortunately, educators often qualify for many tax-free or tax-deferred investment plans. (Traditionally, educators have said that the retirement benefits are worth pursuing a career in education.) These plans allow educators to grow their investments without paying a capital gains tax.

In this blog, I will describe investment opportunities that allow educators to shift their tax payment, lower their tax burden, or grow tax-free income. This blog can also be useful for anyone who is considering a career in education and wants to evaluate or compare the financial benefits with another career option.

(Disclaimer: This blog post only provides information. I am not soliciting investments or making investment recommendations.)

State-Sponsored Teacher’s Pension System

Many states provide a pension system for educators that is an alternative to the Social Security retirement system. In this plan, educators have a portion of their paycheck deducted (like they do for other taxes), and this deduction is contributed into the state pension.

Educators who have these pensions do not pay into Social Security, and they will not draw a Social Security check when they retire (unless they have another job where they do pay into Social Security). However, educators can pay into Social Security if they have a part-time job, summer job, consulting work, book publication, public speaking engagement, or ownership in a private business. For example, law professors may pay into a pension plan from teaching and into Social Security from their work in a law firm. (However, if they draw a retirement income on both, the total amount will be adjusted, so they may have to draw on one first and then on the other.)

The pension system is like an annuity, and there are usually different pensions for K-12 educators and higher education employees.

Like Social Security, the pension system requires a minimum number of years you must contribute, and it has a tiered retirement age requirement for when you can start to draw on your pension (based on years of service), and a method for calculating your monthly pension income (which is usually based on a percentage of your highest salary). As with Social Security, the retirement pension does not run out when you reach a certain age or when you draw out all of your contributions. The pension also provides survivor benefits to your spouse and children, and it may also qualify you for additional state services, such as a state-sponsored healthcare plan.

Unfortunately, educators who start with a pension system today do not have many more advantages that they would have with Social Security, but older employees, who started with an older system, will have better benefits. For example, under an older plan, educators in Illinois can retire with full benefits at age 62 with only 8 years of service, while Social Security requires 40 quarters (10 years) of service and a retirement age of 65. Now, state pensions and Social Security are about the same; for example, full retirement age for both is 67 years.

Additionally, you will have to pay income tax on the retirement pension (it counts as income). But your tax bracket in retirement will probably be lower than it was during your working years, or your total retirement income may be lower than your working salary, thus your tax rate may be lower than what you would have paid while working. Nevertheless, the guaranteed retirement income is a great benefit in itself.

Social Security

Educators who work for private K-12 schools, colleges, and universities, instead of public schools, community colleges, or state universities, will contribute to Social Security instead of a state educators’ pension system.

The Social Security plan for educators is the same as it is for everyone else, and the plan works similarly to a pension, but there are different requirements for years of contribution, retirement age, and how the monthly retirement income is calculated. For example, the Illinois pension plan calculates monthly retirement income from the highest four consecutive years of salary, while Social Security calculates it over 35 years. As a result, monthly Social Security benefits will probably be lower than those of a state pension. And, of course, you’ll have to pay income taxes on the Social Security income.

Nevertheless, Social Security provides a guaranteed monthly retirement income, and it also provides survivor benefits.

401k, 403b, 457b

A 401k, 403b, or 457b is an employer-sponsored retirement investment account, which means you need to work for that school to participate in their retirement plan. All of these plans are optional, and not all of them are available together. Non-profit schools (whether state or private) usually offer a 403b, but a private for-profit educational company may offer a 401k. (Most corporations and private businesses use the 401k.) The 457b is an additional, similar retirement plan that can be offered; I have seen it only with a state school.

The greatest opportunity for tax-free growth happens when the school offers a state retirement pension and optional 403b and 457b plans all at once. This allows you to lower your year-end tax burden and increase the value of your retirement accounts quickly.

All of these retirement plans work the same way. Your employer takes a portion of your paycheck and puts it into an investment account. Their investment manager builds an investment portfolio for the organization, or you can select a self-managed plan where you control your own investment.

There are three big benefits to these retirement accounts.

First, the money you put into your retirement account gets deducted from your gross taxable income. That means that your contribution gets “hidden” from your current taxable income, and you don’t have to pay tax on it this year. For example, if you make $100,000 per year, and invest $20,000 in the 403b, you won’t pay tax on that $20,000; you pay income tax only on the remaining $80,000. If you have both a 403b and a 457b, you can contribute $20,000 into each account, and lower your gross (taxable) income to only $60,000. This works really well for high-income earners because the retirement plans allows them to declare less income. Plus, the tax deduction could put you into a lower tax bracket, where they could pay a lower percentage of tax on your income. But there is a maximum you can put away: around $20,000 per account, plus an additional $6,500 if you are over 50 and did not invest in previous years. Additionally, the more you put away, the less you’ll have to use for student loans, a mortgage, and daily living.
Second, many organizations have a “matching” contribution. This means that your school puts the same amount of money in your retirement plan as you do. For example, if you put $250 of your paycheck into a retirement, your school will put an additional $250 into your account. This is free money! Plus, you get to keep the earnings you make on this employer investment. Well, not totally…. Many employers match only a small amount of your contribution, often only 3% or 6% of your annual income (and maybe nothing at all during bad budget times), and it can be higher for executive leaders and employees with many years of service. Also, many organizations require that you stay with them for a number of years (often, 3 to 5) in order to keep that money. If you leave too soon, you are not “vested,” and your organization will take back the matching contribution it gave you.
Third, the contribution you make to your retirement plan is not totally tax free. You take a tax deduction when you put the money in, but you have to pay income taxes when you take the money out. But (when you become 59.5 yrs), you can choose when you take out the money. Many people do so when they are retired and have very little earned income. As a result, the retirement money is taxed at a low tax rate because they have little income and qualify for a low income tax bracket.
Other Benefits and Limitations: The 401k and 403b are usually tax-deferred, which means you get a tax deduction when the money goes in but pay taxes when it comes out. Additionally, your money is stuck in the retirement account until age 59.5, and you’ll pay a 10% penalty if you withdraw it early, plus many retirement accounts don’t allow you to change investment companies, so you may be stuck with a limited set of investment options. Meanwhile, you may be able to choose whether the 457b is tax-deferred or “Roth.” With a Roth account, you pay taxes on that money before making a contribution, then you can withdraw the money tax free.

Roth IRA (Individual Retirement Account)

There is both a Traditional and a Roth IRA. The Traditional IRA is a lot like the 401k/403b – you get a tax deduction when the money goes in. But the IRA is your personal retirement account; it stays with you, and it is not connected to your employer. The Traditional IRA gets complicated when your employer has a 401k/403b; there are limits on how much you can invest because of the two accounts.

In contrast, the Roth IRA is a personal retirement account you can put money into after paying taxes. It’s basically like a regular savings account. You get your paycheck, pay taxes, and then you can put money into your Roth IRA. But you can put only $6,500 (a little more if you’re over 50), and the money you put in has to be “earned income.” This means you need to have income before you can invest in an IRA; it can’t be your parents’ gift money.

Two great things about the Roth IRA are that:

The investment grows tax free. You don’t pay tax on the investment money you earn. If you opened a Roth IRA in the 1990s, and you invested in Google or Apple or Amazon, and your account is now worth millions, you don’t pay tax on your earnings … unless you withdraw money too early. Basically, if you keep the account until you retire, you don’t pay tax on the earnings.
You don’t pay a penalty to withdraw money you invested. With Traditional IRAs and the 401k/403b, you have to wait until you are 59.5 to take out money. But you can take out the amount you invested from a Roth IRA at any time without penalty. (If you take out more than you put in before you are 59.5, then you are withdrawing the earnings, and you’ll pay a penalty and taxes on that.)

A Roth 457b account works a lot like this Roth IRA account.

Health Savings Account (HSA)

An HSA is another personal savings account you manage. To qualify, you need to have a medical insurance plan that is “high deductible.” This doesn’t mean that your deductible is high. The plan has to be called a “high deductible” insurance plan. If you qualify, you can contribute $7,750 per family, and the investment can grow tax free.

You can only withdraw the money for medical expenses, or five years later, or at retirement age. But the great thing is that you don’t have to withdraw the money immediately. The money for the medical expenses you had in 2020 can stay in there for many, many years. Then, many years in the future, you can withdraw an amount equal to your 2020 medical expenses.

So, if you have enough money to cover your medical expenses out of pocket, the HSA account can become another tax-free retirement account. The HSA has three tax benefits and other conveniences:

You get a tax deduction when you make a contribution. This lowers your gross taxable income, like it does with a 401k/403b.
The money you invest in your HSA account will grow tax free, like it does in a Roth IRA.
You don’t pay tax or a penalty when you withdraw money for medical expenses.
The HSA account can be used like a checking account, where you write checks or use a debit card to pay for medical expenses directly, or you can reimburse yourself later.
You can reimburse yourself at any time; it doesn’t have to be within the same tax year. As a result, you can let the money grow and withdraw years later.

Many people rave about the HSA account because it provides these “triple” tax benefits – a tax deduction at deposit, tax-free growth, penalty-free and tax-free withdrawal (for documented medical expenses).

529 College Education Plan

The College Education Plan is similar to an HSA, but the money needs to be used for educational purposes. Parents and grandparents often open a 529 plan for young kids, and they let the investment grow until the kids can use it for college. But you can also open an account for yourself and use the money to continue your education; anything you don’t use personally can be transferred to anyone else.

As with an HSA account, the 529 plan has triple (actually four) benefits:

You get a (very small) state tax deduction when you make a contribution, and this lowers your taxable income, as it does with a 401k.
The money you invest grows tax free, like it does in the Roth IRA and HSA.
Withdrawals made for educational purposes are tax-free and penalty-free.
The plan can pay school expenses directly, or you can reimburse yourself.
But withdrawals have to be made within the same tax year as the expense. (ie, you can’t pay for graduate school out of pocket now and then reimburse yourself years later, after the investment has grown.)
There is no limit to how much you can contribute, but it can count toward your federal “gifting” limit if you invest more than $75,000. The 529 can be a convenient way to “gift” money to kids and to put a lot of money into a tax-free investment account.

Many states offer their own 529 investment plan, so you can invest in the state-managed investment portfolio, but you can also build your own investment portfolio with the stocks and funds you want. The 529 plan also offers an investor-managed plan, which allows your financial advisor to handle the investing.

With almost all of these investment plans, the benefit is that you can put money into an investment account you control, and the earnings will grow tax free. This is much better than a regular savings, investment, or brokerage account because you won’t be spending a portion of your earnings to pay taxes. But be careful with your investments. Until 2022, retirement investments were growing at 10-15% (and some technology funds at almost 25-30%), while savings accounts were earning less than 1%. But many investment funds in 2022 were in the negative, so retirement accounts lost money.

Tuition Discount or Reimbursement

Many colleges and universities offer discounted or free tuition for their employees, spouses, and children (at the same institution). This can be a great benefit for you if you want to pursue a certificate or graduate degree at your institution and for your spouse or children if they want to attend your institution.

When I worked at a Chicago-area university, many employees were upskilling their education by pursing an MBA or an Ed.D. degree for free. That’s possibly a savings of $20,000-$35,000 for an MBA degree. For a four-year undergraduate degree for your kids, that could be a yearly savings of at least $10,000 for an in-state university and $35,000 or more for a private liberal arts college. The tuition savings alone may be a worthwhile benefit for working in education.

If you or kids don’t want to attend the same school, your institution may offer a tuition exchange program with other schools. This program allows you or your kids to take classes at another school for the same tuition benefit. But this benefit may be difficult to qualify for; it’s often based on a system of credits and debits, employee seniority, and a limited number of spaces. Nevertheless, if your school offers it, and you qualify, it could save you a large expense.

Finally, many employers (not only schools) offer tuition reimbursement for employees who continue their education. According to Quantic, employers offer an average of $5,250 for undergraduate degrees and $10,500 for graduate degrees. While this benefit may exist in the corporate world, I have seen a tuition reimbursement of only $1,000-$2,500 per year where I have worked. However, your school may decide that it’s a strategic priority for you to get another degree – so you can teach a new set of courses or lead a new academic division – and it may be willing to pay for your whole degree. College faculty may also have a unique tuition benefit they negotiated as part of the union contract. For example, faculty at a couple of my schools could get full tuition reimbursement for their first Ph.D. degree.

In many of these cases, you may need to meet specific requirements, such as years of service, seniority, or job classification (faculty/staff, full-time/part-time, tenured/non-tenured), and you may need to remain with the organization for a number of years after they have reimbursed you (they don’t want to upskill you just so you can leave).

Whole Life Insurance

Whole Life Insurance is life insurance with an investment plan. As with any life insurance, your beneficiaries will receive the value of your life insurance when you pass away; for example, if your life insurance is worth $100,000, your beneficiaries will receive $100,000 when you pass away.

However, Whole Life Insurance also acts as an investment plan. The money you put into your Whole Life plan grows over time. So, when you pass away, your $100,000 insurance plan will be worth more than $100,000. And you usually put in much less than you can take out. For example, you likely contribute less than $100,000 for a Whole Life Insurance policy that pays out $250,000 at death. So, in this case, the investments provides an automatic 2.5X return.

That’s great for your beneficiaries, but how does a Whole Life plan benefit you? Whole Life Insurance can act like another retirement account; it allows you to withdraw a portion of the money you have put in. In this sense, a Whole Life plan becomes another long-term investment plan. (Of course, the money you withdraw will get subtracted from the total value of the insurance, so the amount paid at death will be less; nevertheless, many people use Whole Life Insurance as another tax-free long-term investment plan.)

The Whole Life Insurance plan has many benefits:

You can invest as much as you want. Life Insurance is expensive, so you may not be able to afford to invest too much, and there are some guidelines about how much insurance you should get (based on your income), but, in general, there are no limits (like there is with the 401k, IRA, or HSA). And your investment money can come from savings; it doesn’t have to come from “earned income.”
You get more than you contribute. Life insurance is based on the end-of-life amount you want your family to receive. But you don’t have to invest that same amount. If you start early, you will put in significantly less than you get out. As a result, the life insurance will pay two, three, or four times what you invested.
The investment growth is tax free. It’s tax free for you, and it’s tax free for your family when they receive the funds after you pass away. There are some limits to this; as with the Roth IRA, you can’t withdraw more than you put in, but, if you stay within that limit, it’s tax free growth.
You can withdraw money before you pass away, and there will still be an end-of-life amount. Life insurance is for the family you leave behind. But a Whole Life plan allows you to withdraw some of that money before you pass away (tax free). Essentially, Whole Life is like a Roth IRA with an additional end-of-life amount for your family.

Summary

Educators have access to many tax-deferred and tax-free investment options as employees of (American) organizations, and they may have access to unique retirement plans that private and corporate sector employees do not have. These retirement plans and benefits can help make a career in education financially rewarding in the long-term, even if an educational career does not provide a high salary. As you consider a career in education, or are trying to plan for retirement, consider how these tax-deferred and tax-free investment accounts and other benefits can help you secure your financial future.

Lirim Neziroski, Ph.D., MBA is a higher education administrator, education consultant, and previous faculty member with expertise in higher education leadership, instructional technology, curriculum development, academic assessment, academic and online programs, and strategic planning. Contact Lirim for consulting, mentoring, research, writing, and public speaking services.