Consider Tax Diversification when Saving for Your Future

Ever think about the best account types to save for financial independence, retirement, and long-term goals? I’m talking about tax-deferred, tax-free, and taxable accounts, specifically.

Tax-deferred accounts are your typical savings vehicles for pre-tax dollars, like your company 401k pre-tax option where you get a current year tax deduction for any dollars you contribute.

A tax-free account would be a Roth IRA or the Roth option within your company 401k plan. In this case, “tax-free” is referring to the growth within the account rather than the money you contribute. Contributions are made with after-tax dollars, but the account is never taxed again…EVER (provided you follow a couple of simple rules: 1) you must have a Roth IRA that has been open for at least five years, and 2) you must wait until age 59 ½ to withdraw any of the growth).

A taxable account would be the typical brokerage account where you contribute after-tax dollars and pay taxes on income and capital gains the investments produce each year. Under current tax law, long-term capital gains (i.e., gains that you realize from the sale of an investment you held for more than a year) and dividends from stocks, mutual funds, and ETF’s receive favorable tax treatment. They are taxed at 0%, 15%, or 20%, depending on your taxable income for the year.

A Health Savings Account (HSA) is an especially attractive account type if you participate in a high-deductible health plan. Contributions to an HSA are tax deductible on the front end, and the money (both the growth and your contributions) comes out tax-free on the back end if you use it to pay for qualified medical expenses.

Consider the following when thinking about which of these account types to focus on for your future financial independence:

Tax-deferred accounts

Withdrawals are taxed as ordinary income, and with a few exceptions, you must be at least 59 ½ to avoid a 10% penalty when taking a distribution.

At age 72 (under current law), you MUST begin making withdrawals (called Required Minimum Distributions or RMD’s) according to an IRS life expectancy table to avoid a 50% penalty on the amount you should have withdrawn and didn’t (Uncle Sam wants his tax money).

There is a notable exception here…if you continue to work past age 72 and have a 401k with that employer, you do not have to take RMD’s on that 401k until you retire or leave the company.

Beneficiaries of a tax-deferred account (other than your spouse and a few other less common beneficiaries) must empty the account within ten years following the death of the account owner (and pay ordinary income taxes on the distributions).

From a tax perspective, think about a tax-deferred account this way: You really only “own” 70% or so of the money in the account and Uncle Sam owns the other 30%. You’re a joint owner with the IRS!

The reason to put money into a tax-deferred account is simple: You want tax savings right now.

The dollars you put into a tax-deferred account (or an HSA) give you a current year tax deduction. If, for example, your current effective tax rate is 35%, a $100 contribution to a tax-deferred account will only reduce your take-home pay by $65.

 

Tax-free (Roth) accounts

Provided you’ve had a Roth IRA for at least five years and you are at least 59 ½, your Roth money is TAX-FREE FOREVER!

Any money YOU CONTRIBUTE to a Roth IRA can be withdrawn tax-free and penalty-free at any time…regardless of your age.

For example, say you’re 35 years old, you contribute money to a Roth IRA, and then you have an emergency that requires you to withdraw the amount you contributed. You can pull out the money you contributed with no taxes or penalties…that’s because those dollars have already been taxed.

I do not recommend this…Roth money is special, and you should accumulate as much as you can for as long as you can. But the dollars you put in are there if you need them without penalty or taxes at any time.

Money in a Roth IRA grows tax-free, FOREVER! Well, not exactly. See the next point for the caveat.

Beneficiaries of a Roth IRA do not pay taxes on distributions from the inherited account; however, other than the spouse, beneficiaries do have to empty the account within ten years following the death of the account owner…Uncle Sam wants the beneficiaries to take that money out and put it someplace else where the growth can be taxed.

Money can be withdrawn from a Roth account for certain other specific and nuanced purposes without penalty; however, I’ll save that for another article.

You “own” 100% of the money in the account (no partnership with the IRS with a Roth).

Tax-free (HSA) accounts

HSA accounts are triple-tax-advantaged. Here’s the breakdown:

You make Tax-free contributions on the front-end
You get Tax-free growth on the money in the account
You take Tax-free withdrawals – if used to pay qualified medical expenses

NOTE: There is a steep 20% tax penalty if you use the money in an HSA for anything other than qualified medical expenses prior to age 65.

No FICA taxes are withheld on contributions made to an HSA via payroll withholding through your employer.

This is a big deal. That’s an extra 7.65% in your pocket (over and above the tax savings you get for 401k contributions).

You can take tax-free withdrawals to reimburse yourself for qualified medical expenses at any time in the future, meaning you could leave the money in the account for decades to grow before you reimburse yourself…just keep good records if you go this route rather than paying for medical expenses directly from the account.

Once you reach age 65, you no longer have to pay a 20% penalty on withdrawals for non-qualified medical expenses. In other words, the account acts like a tax-deferred IRA after age 65 for taxation purposes if you use the money for anything other than qualified medical expenses. But who expects to have NO medical expenses in retirement?

An HSA might just be the most tax-advantaged account available. If you have a high-deductible health plan, you should seriously consider maxing out a Health Savings Account.

 

Taxable accounts

Contributions/deposits are made with after-tax dollars.

Gains from the sale of assets that have gone up in value incur capital gains taxes.

Losses from the sale of assets that have gone down in value can offset any gains and an additional $3k of ordinary income per year.

If an investment is held for more than a year, gains from its sale are considered long-term and have a lower tax rate than gains from the sale of an investment held one year or less (which are called, you guessed it, short-term capital gains and are taxed as ordinary income).

There are no restrictions on the use of money in a taxable account prior to age 59 ½ like there are with tax-deferred and tax-free accounts. You can use the money for current or future needs.

Current law allows for a step-up in basis when beneficiaries inherit appreciated assets (meaning the heirs can sell assets immediately upon inheritance with no tax consequences, even if the assets were originally purchased at a much lower value).

This step-up does not apply to tax-deferred accounts…the beneficiaries of tax-deferred accounts must pay ordinary income taxes on any withdrawals.

NOTE: This rule, along with many others related to investment and retirement accounts, is getting a lot of attention in Washington and could go away one day…with major tax consequences for estate planning.

 

Takeaways

Consider saving for your retirement and long-term goals in all three of these account types to achieve tax diversification. This gives you greater control over your effective tax rate in retirement by allowing you to fill up the lower tax brackets with withdrawals from less tax-efficient accounts, like tax-deferred IRA’s and 401k’s, and to use your tax-free Roth assets in strategic ways in the higher tax brackets (i.e., for large one-time expenses, during times of high tax rates, or in later retirement years when RMD’s force you into a higher tax bracket).

I realize many folks reading this post may not qualify for Roth IRA contributions directly due to your income; however, more and more 401k plans, especially at technology companies, are offering Roth options, and 401k plan Roth contributions are not limited based on income. There are also other creative ways to get money into Roth accounts (at least until Congress eliminates some of the conversion strategies available today…elimination of those strategies is one of the items contained in the most recent Build Back Better plan passed by the House back in November; that bill stalled in the Senate). I’m happy to discuss these conversion strategies and other topics if you’re interested. Just schedule a call.

Allocation of your investment dollars across these three account types is more art than science; however, you ideally want to have at least a significant percentage of your long-term assets in each of the three tax buckets to have more control over your FIRE options and effective tax rate in your retirement years.

How to save

Automation is the key

For 401ks, HSA’s, and ESPP’s, automated savings through deductions from your paycheck is your only option, and it’s a good one (NOTE: you CAN save to an HSA directly without a payroll deduction; however, you avoid paying Social Security and Medicare taxes – otherwise known as FICA – if done through a payroll deduction).

For taxable brokerage account deposits, you can do this through a direct deposit from your paycheck or by transferring money from checking or savings to the brokerage account; however, even the most disciplined among us will struggle to consistently save if the money makes it into our checking account. Direct deposit from your paycheck will ensure that a specific amount is deposited to your brokerage account every time you get paid.

If you’re lucky enough to receive RSU’s, another method for funding your taxable brokerage account involves selling RSU shares immediately when they vest (which is a taxable event regardless of whether you sell them) and moving the cash to your brokerage account to invest.

Hopefully this post got you thinking more about how and where to save and the available options. The most important thing, though, is that you are saving somewhere.

If you’d like to learn more about the technical details of these and other personal finance topics and how they could help move you closer to your financial goals, reach out and schedule a free consultation or send me an email.