Category: Taxes

Categories
Taxes

The Retirement Tax Triangle: Give Yourself Options

BLUF: It’s impossible to predict how future tax laws will change. By saving in all retirement tax triangle accounts with diverse tax treatment we give ourselves more options to control our taxation in retirement.

When you get into the details of saving for retirement, one thing you figure out is that not knowing the future makes planning really hard. One planning area where this is especially difficult is the area of taxation. One this is for certain though, you’re going to have to deal with taxes in retirement.

Income taxes, capital gains taxes, federal, state, foreign…big brother wants a piece of your money. If you’re…human, then you despise taxes and want to do what you can to minimize those taxes and keep that money.

In this article we’re going to talk about the different ways that you can diversify your investment holdings from a taxation perspective. We’ll walk though examples of how those different tax treatment buckets gives you options to minimize your taxes in creative ways.

The Tax Triangle – Helping To Plan For Future Tax Uncertainty

white moon on hands
Photo by Gantas Vaičiulėnas on Pexels.com

Why is this topic important in retirement planning? As previously mentioned, paying taxes are one certainty that isn’t going to change. Taxes add on to your future liabilities so you need to account for them in your FI number.

In retirement and early retirement it’s likely that your effective tax rate will fall as most of us will have less income, but it won’t be zero. The 4% rule of thumb doesn’t account for taxes so you need to plan for that as a separate expense.

Oh, and the government changes the tax laws A LOT. Here’s just a sample of the major legislation impacting taxes that has passed over the last 25 years. Well within a normal retirement period. I don’t envy the CPA’s that have to keep up with all of this!

As you can see, it’s a near certainty that US tax laws are going to change over the course of any persons retirement. The laws tend to change in some way every 3-5 years.

As you’ll learn, putting money in all three tax buckets give us some amount of control of our tax rate. We don’t make the tax laws but the amount of income that we can draw from each tax bucket allows us to manipulate our effective tax rate in any given year.

Retirement Income Sources

pexels-photo-164527.jpeg
Photo by Pixabay on Pexels.com

Many people are working for others as either a 1099 contractor or W-2 employee to make a living. Other than contributing to tax advantaged retirement accounts you don’t have much control over how you’re taxed.

In retirement, however, you have the ability to draw from a number of potential income sources which get different tax treatment.

  • Guaranteed Income – Pensions, social security (ordinary income taxes), annuities (taxation varies)
  • Business Income – Real estate income, other business income (taxation varies)
  • Taxable Investment Accounts – Brokerage accounts (capital gains taxes)
  • Tax Deferred Investment Accounts – Traditional IRA accounts (ordinary income taxes)
  • Tax Free Investment Accounts – Roth IRA, Health Savings Account (HSA) spent on qualified expenses (tax free)

Guaranteed income is great, but your options are limited on controlling taxation of that money. Business income is very situation specific and is outside the scope of this article. We’re going to focus on the last three investment account options for giving us tax options in retirement since those are more broadly available.

The Retirement Tax Triangle

The tax triangle is a way to describe three different categories of investment accounts that each receive different tax treatment. These categories are: tax free, taxable and tax deferred.

Tax Free Accounts

No taxes are due on the sale of investments or withdrawal of money in tax free accounts as long as the correct rules are followed.

Roth versions of retirement accounts are the most common. You can buy, sell and withdraw contributions at any time. After age requirements are met you can withdraw investment gains tax free. You contribute to them with after tax money.

I wish my parents had started a Roth account for me as a teen, or had at least knew about the Roth early in my 20’s. At $6k/yr it requires a lot of time to build up a lot in that bucket unless you have access to the mega backdoor Roth.

HSA’s, covered extensively here, can be invested. Buying and selling of investments in those accounts is not taxable. When you withdraw money from the account for qualified medical expenses the money is tax free even though you got to contribute to the account with pre-tax dollars!

Cash! There’s no tax on the withdrawal of cash held in bank accounts or taxable investment accounts.

Taxable Investment Accounts

These investment accounts are your standard brokerage accounts at Schwab, Fidelity or Vanguard. You move after tax money into these accounts and invest your money as desired. These could also be crypto brokerage accounts.

Any sale within these accounts is a taxable events and income distributions in the form of interest and dividends are subject to tax. However, investments held for a year and a day and sold get the advantage of special long term capital gains (LTCG) treatment. If you don’t hold investments for over a year and sell them they are considered short term capital gains (STCG) and are taxed as ordinary income like your paycheck.

LTCG get taxed at 0%, 15% and 20% LTCG taxation rates in 2022 which is MUCH lower than ordinary income tax rates. For example here’s how the ordinary tax rate has compared to the the LTCG tax rate in recent years.

Notice that 0% tax bracket? That’s a taxation sweet spot that we’ll discuss more. We definitely want to take advantage of that when possible!

*Starting in 2018 the ordinary income tax brackets aren’t tied to the LTCG tax brackets. They’re close for the 0% and 15% brackets, quite a bit different for the top of the 15% bracket

Tax Deferred Investment Accounts

These are some of the most common retirement accounts as they’ve been around the longest. The money is called tax deferred because you get to contribute to the accounts pre-tax, let the money grow without taxation and then the taxation happens when you withdraw the money from the account.

The money withdrawn from the accounts are taxed as ordinary income when withdrawn from the account at your marginal tax bracket. These taxation rates for ordinary income and their taxable income ranges are shown below.

These are most commonly called traditional accounts. Examples of common retirement accounts that are tax deferred are the tradition versions of an IRA, 401k, 403b, 457b and Thrift Savings Plan (TSP).

How Income “Stacks” For Taxation

Before we talk about some of the ways that the tax triangle can be used to minimize taxes in your situation, it’s important to understand the ordering rules for taxing of your income.

Think of taxation order as a cake and the layers are taxed starting at the bottom and working your way up.

Standard Deduction: Your standard deduction is removed from your ordinary income layer first. In 2022 this is $25,900 for joint filers. If for some reason your ordinary income is less than your standard deduction then it’s used to reduce your long term capital gains.

It’s important to remember that when you look at income tax tables, what is shown is the taxable income left AFTER the standard deduction is removed.

For example, if you made $40,000 in ordinary income as a married couple in 2022, your taxable income after the standard deduction is $40,000 – $25,900 = $14,100. Taxed all at the 10% marginal bracket you’d pay $1,410 in tax for the year on that $40,000 income.

Ordinary Income: Everything that is taxed as ordinary income falls into that layer as the bottom layer. All earned income resides here including salaries, interest income, bonuses, short term capital gains and traditional IRA withdrawals. Social security has some unique tax treatment so it isn’t just taxed completely as ordinary income.

Frequently misunderstood: Bonus tax treatment.

Bonuses are taxed as ordinary income. Your employer may withhold extra money from a bonus but it’s not taxed any differently than your salary. In the end, if you paid extra extra tax on a bonus up front then you’ll get it back at tax time.

Long Term Capital Gains: Investments sold in taxable investment accounts and qualified dividends paid (whether reinvested or not) are all income that receives long term capital gains treatment. As you can see below, the tax rates are FAR lower than ordinary income.

Tax Free Income: Income from Roth withdrawals is tax free as is withdrawals from bank accounts or cash inside brokerage accounts.

LTCG Calculation Example

This may seem obvious to some, but it’s critical to understand how to calculate long term gains properly. It is common to confuse the gains of a sale with the overall cash received from a sale. Let’s walk through an example to make sure that it’s clear.

In 2021 you purchased 200 shares of VTSAX in a taxable brokerage account for $100 per share. This is your cost basis for the investment – what you payed for it. In 2025 those shares were worth $150 per share and you sold all 200 shares.

Your brokerage account would show $30,000 in cash from the sale, but you’re only taxed on the capital gains. In this case, you’re taxed on $10,000 of long term capital gains.

Newer investments that haven’t had time to appreciate as much will have less capital gains as a percentage of the sale. Older investments that have had more time to grow will have more capital gains as a percentage of the sale.

Examples Of Tax Triangle Drawdown Flexibility

Now, for the fun part. Showing how having funds in all three buckets of the tax triangle gives you options to control your tax rate. I know, I have a weird idea of fun.

Let’s pretend that for all scenarios a married couple (age 60) needs $60k/yr after taxes to live and are retired. They have no pensions and they won’t take social security until 67. The year is 2021 and those tax brackets will apply. The couple lives in a state that has no state income tax.

Scenario #1: $2M in traditional 401k’s. No money in Roth or taxable accounts. Withdrawing enough to live on, $60k after taxes.

In this case you have limited options. All that money is taxed as ordinary income. You need to pull out $64,310 which will result in you paying $4,310 in federal income taxes. Your effective tax rate is 6.7% ($4,310 / $64,310).

Source: Nerdwallet 2021 Federal Tax Calculator

Scenario #2: $2M in traditional 401k’s. No money in Roth or taxable accounts. Withdrawing enough to live on, $60k after taxes. Also, complete $60k in Roth conversions (net of taxes) to reduce future required minimum distributions (RMDs).

Once again, your options are limited to just withdrawing more money from the 401k accounts pushing you into higher tax brackets to pull enough money to cover the Roth conversions. As a result, you need to pull $135,972 from the 401k paying $15,972 in federal income taxes. Your effective tax rate is 11.7% ($15,972 / $135,972).

Scenario #3: $1M in traditional 401k’s. $500k in Roth and $500k in a taxable account. The couple needs $60k to live and wants to do a $60k Roth conversion. The $60k to live is pulled from the Roth IRA.

In this case, the couple is going to do the $60k Roth conversion from their 401k. That money is all taxable income and they pay $4,310 in taxes just like in scenario #1. Since $60k in Roth money is withdrawn to live on that is tax free. In total $4,310 in tax was paid on $124,310 ($64,310+$60,000). A total effective tax rate of $4,310 / $124,310 = 3.46%.

Source: Nerdwallet 2021 Federal Tax Calculator

Scenario #4: $1M in traditional 401k’s. $500k in Roth and $500k in a taxable account. Taxable account has 5,000 shares of VTSAX at a $50 cost basis, $100 current share price. The couple needs $60k to live and wants to do a $60k Roth conversion. The $60k to live is pulled from the taxable account.

In this case, the couple is going to do the $60k Roth conversion from their 401k. That money is all taxable income and they pay $4,310 in taxes just like in scenario #3.

Source: Nerdwallet 2021 Federal Tax Calculator

To get $60k to live on the couple sells 600 shares of VTSAX at $100/ea resulting in $60k in their account. The capital gains on those are 600 shares * ($100/share – $50/share cost basis) = $30,000.

The taxable income is $39,210 in ordinary income from the Roth conversion + $30,000 in LTCG taxes = $69,210 in taxable income. Since this amount is less than $80,800 it’s in the 0% LTCG bracket and the couple will pay $0 in tax on that $30,000!

This makes the taxable account act like a tax free Roth account as in scenario #3. In total $4,310 in tax was paid on $124,310 ($64,310+$60,000). A total effective tax rate of $4,310 / $124,310 = 3.46%.

There are obviously an infinite number of scenarios that could play out using the combination of these accounts. In other words, lots of options!

What’s The Ideal Tax Triangle Mix?

We all love to have definitive answers to questions like this. Unfortunately, there is no perfect answer. The key is to understand the impact of having money in the account mix that you have and coming up with a plan for how you will empty those accounts in retirement.

I think there’s power in trying to save some percentage in all of these accounts as you saw from the earlier scenarios. It gives you the flexibility to deal more effectively with future tax legislation changes.

Some things to think about:

  • Think about your own retirement plans and how these accounts will fit into them. Begin with the end in mind and see if your current account mix would work with a drawdown plan.
  • If you have a long period planned with no or low income, you can get away with larger tax deferred balances. You can withdraw or Roth convert down those balances before social security or pensions start.
  • Roth contributions today instead of traditional IRA contributions eliminate a tax liability in retirement.
  • Long term capital gains tax rates have historically been much better than ordinary income tax rates.
*Starting in 2018 the ordinary income tax brackets aren’t tied to the LTCG tax brackets. They’re close for the 0% and 15% brackets, quite a bit different for the top of the 15% bracket

What Am I Doing?

If you read my last article about our portfolio composition, you saw this portfolio breakdown below. Traditional 401k accounts dominate our portfolio at the moment at 62.5%. At the moment we’re also saving $50k into tax deferred accounts each year which is also the most that we add to any account. This will accelerate the imbalance although the goal isn’t necessarily to be in balance.

The goal is to make sure that you have some diversity in investment locations and a plan for how to unwind those in a tax optimized way. It’s good to plan but don’t get too fixated on it. Tax planning is based on many variables that are out of control that change frequently. Taxation levels, tax laws and your relationship status (single/divorced/widowed vs. married) all can have major impacts.

In 2026, if no tax legislation changes first, the Tax Cuts and Jobs Act of 2017 will expire and ordinary income tax rates will increase. 12% -> 15%. 22% -> 24%. 24% -> 28%. Mrs. MFI and I both have options to invest in Roth 401k accounts.

Current tax rates are historically low but at our high income they’re still higher than I’m likely to encounter in retirement. Do I want to pay a locked in 24% tax today by switching to a Roth 401k to avoid paying taxes in retirement that are likely lower, but still variable in rate? I don’t know. That’s a tough one that I’m going to have to ponder some more and do some math.

Key Takeaways:

  • Tax legislation is ever changing and impossible to predict.
  • Investing in a mix of tax deferred, taxable and tax free accounts gives you the greatest flexibility in retirement tax planning.
  • Investing in tax deferred accounts today means avoiding taxes at todays ordinary income tax rate in exchange for taxation on this money at future ordinary income tax rates. There will be RMDs. However, keep in mind that you’ll be declaring less income in retirement so your taxes should be far less because you’ll lower tax brackets.
  • Investing in Roth accounts today means being taxed at todays ordinary income tax rate in exchange for no taxation in the future. There are no RMDs.
  • Investing in taxable accounts today means being taxed at todays ordinary income tax rate in exchange for special tax rates in the future. There are no RMDs.

Like the content? Click here to subscribe to the e-mail list and have the articles delivered to your inbox.

Categories
Expenses Investing Saving Taxes

Health Savings Account (HSA): The Best Tax Advantaged Account

BLUF: The health savings account (HSA) is one of the best tax advantaged accounts that you can have. Use the tactics in this article to save big on taxes and create a money machine to fund retirement medical expenses.

Oh, it’s that time of year again. Benefits election time for all of us working those W2 jobs and for those using a variety of other healthcare sources. It felt like an appropriate time to talk about the amazing tax advantaged account that I and Mrs. MFI ignored for far too many years. I am talking about the Healthcare Savings Account (HSA)!

Tired Dog GIFs - Get the best GIF on GIPHY

Yeah, not the most exciting topic on the surface. You know what is exciting? Sticking it to the tax man and keeping more of your sweet sweet money. This account can also help you retire early and worry a bit less about long term care costs. Intrigued? Read on…

What am I going to cover? Three basic areas:

  1. HSA Overview – All the key foundational details about HSAs: What they are, who can open one, what you can buy with them and why they’re awesome.
  2. HSA Basic Tactics – What are some simple ways to take advantage of that account?
  3. HSA Advanced Tactics – Some much more creative ways that you can use this account to your advantage over the long term.

HSA Overview

If you already have knowledge of HSA’s feel free to skim through this next section. It’s dry, but necessary because it defines the rules around these accounts. The devil is in the details!

What Is An HSA?

Right from the IRS:

A Health Savings Account (HSA) is a tax-exempt trust or custodial account you set up with a qualified HSA trustee to pay or reimburse certain medical expenses you incur. You must be an eligible individual to qualify for an HSA.

No permission or authorization from the IRS is necessary to establish an HSA. You set up an HSA with a trustee. A qualified HSA trustee can be a bank, an insurance company, or anyone already approved by the IRS to be a trustee of individual retirement arrangements (IRAs) or Archer MSAs. The HSA can be established through a trustee that is different from your health plan provider.

https://www.irs.gov/publications/p969#en_US_2020_publink1000204023

Who Can Have An HSA?

Here are the requirements to qualify for an HSA:

  1. You are covered under a high deductible health plan (HDHP) on the first day of the month.
  2. You have no other health coverage except what is permitted (see the IRS here for details under Other Health)
  3. You aren’t enrolled in Medicare.
  4. You can’t be claimed as a dependent on someone else’s tax return from last year.

The key requirement for most is making sure that you have a HDHP. Not sure if you have one? Read here for how to tell.

Each person covered by an HDHP is allowed to have their own HSA account. Or, in a family situation, a single adult could have the family HSA and cover the expenses of the other spouse and dependents. There is no such thing as a “joint” HSA.

If you’re married and have a family plan then your spouse can have their own HSA if they’re covered by your family HDHP!

Quadruple Tax advantage

Why is this account awesome? So many tax advantages. HSA, oh how I love thee helping me stay tax free. Let me count the ways:

  1. Tax free going into your account if paid via a payroll deduction – No federal, state OR FICA taxes paid on the contributions.
  2. Reduces your taxable income – HSA contributions reduce your adjusted gross income (AGI) so you save taxes from your highest marginal tax bracket.
  3. Grows tax free – An HSA can be invested in stocks, bonds, ETFs and mutual funds and all growth is tax free. You can buy and sell within the account without any tax consequences.
  4. Tax free withdrawals for qualified medical expenses – As long as you use the HSA to pay for the IRS defined qualified medical expenses then the money comes out tax free as well.

An HSA is truly a special account.

It's MAGIC - Reaction GIFs

Who Can Use The HSA Funds?

More than you might realize. Qualified medical expenses are those incurred by the following persons.

  1. You and your spouse.
  2. All dependents you claim on your tax return.
  3. Any person you could have claimed as a dependent on your return except that:
    1. The person filed a joint return;
    2. The person had gross income of $4,300 or more; or
    3. You, or your spouse if filing jointly, could be claimed as a dependent on someone else’s 2020 return.

That means that even if you have partner #1 on a HDHP and partner #2 on a traditional HCP then you can use partner #1’s HSA for expenses incurred by partner #2.

Who Can Contribute To An HSA?

Anyone currently covered by a HDHP and has an open HSA can contribute money to it up to the annual limits.

How Much Can You Contribute?

The amount that you can contribute to an HSA varies each year so be sure to check to see what the latest limits are by searching for “IRS HSA contribution limits XXXX (year)”. The information in the tables below are for people that had plans for the entire year. Review the IRS website here for information on partial year contributions.

2021 HSA Limits Under Age 55 Age 55 or Older
Self Coverage$3,600$3,600 + $1,000 extra
Family$7,200$7,200 + $1,000 extra per spouse over 55
2022 HSA Limits Under Age 55 Age 55 or Older
Self Coverage$3,650$3,650 + $1,000 extra
Family$7,300$7,300 + $1,000 extra per spouse over 55

Unlike your 401k, employer contributions to your HSA DO count towards the annual max. For example, in 2021 if a single employee had an HSA and their employer contributed $1,000 to it then the employee could only contribute $2,600 more to hit the $3,600 annual max.

How Can HSA Funds Be Used?

What is reimbursable by an HSA? There are a LOT of things actually. Here is a selection of both common and unusual items that are covered:

  • Artificial Limbs
  • Birth Control Pills
  • Capital expenses to your home for medical care (widen doorways for a wheelchair, for example)
  • Dental Treatment
  • Eyeglasses
  • Fertility Enhancement
  • Guide dog or other service animal
  • Medicare Part B,D premiums
  • Menstruation Care Products
  • Nursing Services
  • Over the counter (OTC) drugs without the need for a prescription
  • Therapy
  • Transportation and Lodging to another place for the purpose of a medical procedure

Unfortunately, private health insurance premiums aren’t covered except in very narrow circumstances (COBRA). Sorry, no medical marijuana either.

Full list of qualified medical expenses here:

Be careful to not take unqualified distributions from the account before age 65. If you do those distributions are taxed as ordinary income AND subject to a 20% penalty. Ouch.

Do HSA Funds Ever Go Away?

No. To have and to hold, until death do you part. When you die your HSA will pass tax free to your spouse and they will enjoy the same tax free benefits. There are also

But what if I end up with more in my HSA account than I could possibly use? Easy, after age 65 you can withdraw money for non-healthcare expenses and it’s taxed as ordinary income.

HSA Tactics – Getting The Most Bang For Your Bucks

Now, lets talk about the fun topics. What are the different strategies that you can use to get the most of your HSA. I’ll present a variety of tactics and you can choose what best fits your situation.

I’m going to list these roughly in order from the more basic approaches and then heading to the more advanced and niche.

Use An HSA Debit Card To Pay For Expenses

Starting with the most basic approach. Save money in your HSA account in cash and whenever you have a qualifying healthcare expense, use your debit card to pay for it. The $4,928 listed below are all expenses that I paid directly from my HSA earlier in life.

It’s simple, convenient and is letting you use pre-tax dollars to pay for expenses that otherwise would be post tax. How much did that save me?

Well, our effective federal tax rate is about 15%. That means that we would have had to made about $5,800 in wages to pay for $4,928 in medical expenses net of taxes. $872 saved!

Investing With An HSA:

Saving money is great, but being FI minded we want our money to work for us. A beautiful thing about an HSA is that this isn’t just some crappy bank account where the money earns no interest. Oh no my friends, you can invest it!

You can connect the HSA to an investment account with firms like Fidelity (Mrs. MFI) or TD Ameritrade (Mr. MFI) and invest the money. It varies by HSA provider, but you generally need a minimum cash balance ($1,000 to $2,000) before they’ll allow you to start investing HSA money.

My HSA actually has two pieces: A cash account in a bank where all distributions are paid from and an investment account which are linked together but are operated by different companies. Mrs. MFI has a similar arrangement but with a different bank and investment company.

My work HSA is connected to TD Ameritrade and every paycheck it sweeps money to the TD Ameritrade invested HSA. I have the account setup to leave $1,000 (the minimum) in the HSA bank cash portion and sweep anything more into my HSA investment account.

Here are those auto sweep transactions happening every two weeks when I get paid.

That money can then be invested in whatever I choose on the platform. I’ve got the money invested in an ~80/20 split of VTI and BND. It’s a tax advantaged account so I can rebalance or change investments (sell) without any tax consequences.

Quarterly I’ll go in and make a purchase with the cash that’s accumulated. Looks like I’ve been slacking and have $1,280 accumulated that needs investing.

Clearly this year has been incredible unusual as far as US stock growth. YTD this basic invested HSA is up almost 50% or $6,000. Far more than I’m allowed to contribute to the account in a single year.

Vanguard for some reason has decided to stay out of this HSA market for the time being.

HSA Advanced Tactics

Now, for some fun stuff. How can you actually take the use of this fancy HSA to the next level and stack these benefits? Let’s explore that. I love nothing more than to find legitimate ways to game the system. Some of these ideas you can stack and use together.

Pay For Medical Expenses With A Cash Back Credit Card

woman in white long sleeve shirt sitting on chair
Photo by Mikhail Nilov on Pexels.com

A key thing to understand about an HSA is that you can reimburse yourself tax free from that account, regardless of how you pay for the medical bill.

Knowing that, why would you ever use an HSA debit card to pay for a medical expense? I’m a huge fan of credit card rewards so I put as much as possible on my cards. I use the Citi DoubleCash credit card for 2% cash back on everything. If you spend $3,000 a year on medical bills that’s still $60 cash back for nothing.

Then you can submit to your HSA provider for reimbursement of that expense from your account. Here’s a key point. Your HSA provider isn’t necessarily going to check that what you’re submitting for is a legitimate expense. The IRS is the one that may come knocking and ask for proof that these were legitimate expenses.

For that reason, it’s important that you keep sufficient proof that the bill that was paid by your HSA was for a qualified medical expenses. Here’s what the IRS says you need to keep for records:

Source: https://www.irs.gov/publications/p969#en_US_2020_publink1000204088

How should you keep these records? I’m a big fan of Google Drive. I recommend keeping a copy of record which has the details of the service, proof that you paid the bill and when it was paid.

Use Medical Expenses To Hit A Credit Card Sign Up Bonus

If you’ve read the blog then you know I’m a fan of credit cards for travel rewards. A key part of travel rewards is to open a card with a great sign up bonus (SUB) that’s paid when you hit a minimum spending level.

No better way to hit a minimum spending level than to charge medical bills to a new credit card. Then you can use your HSA to pay yourself back. Medical bills are a pretty good candidate for this since there’s a big lag between the service and the bill arriving. Plenty of time to apply and get a new card. The bigger risk might actually be that they take TOO long to bill you.

One thing to be aware of is that if you pay a bill with a credit card then you give up your ability to negotiate down a larger bill. So, make sure that you do that first before paying the bill.

Take a medical tourism trip and partially reimburse yourself with your HSA.

This one seems like cheating but it’s in the rules. If you have a trip that you’re taking for medical tourism purposes then you can pay for transportation and some of your lodging with your HSA. By that I mean that you’re traveling to another location for the main purpose of having a medical procedure done.

Mexico is popular for very cheap dental care so if you had an expensive surgery this would be a great option. Take the trip, save a lot on the procedure, pay for it all on your favorite credit card. Then reimburse yourself for part of the trip and the surgery with your HSA. How sweet is that?

Source: IRS Publication 502 – Medical and Dental Expenses, Page 14

Pay For Medical Expenses Out Of Pocket, Let Your HSA Grow

Up until now we’ve been talking about paying for your medical expenses out of the HSA because it’s all tax free. The next idea might seem counter intuitive but you could pay for medical expenses out of pocket and NOT reimburse yourself from your HSA right away.

Why might you do that? The power of compounding. If you constantly spend the money that you contribute to the HSA then that money never gets a chance to compound. However, suppose that you let those HSA contributions grow to $50,000. By the 4% you could withdraw $2,000 a year and have a high likelihood of not running out of money over 30 years.

A Secret Emergency Fund

Here’s another trick. If you pay for medical expenses out of pocket you can reimburse yourself anytime in the future from your HSA. For example, I spent $3k this year on medical expenses (not my best year) but paid out of pocket.

I have those receipts and 10, 20 or 30 years from now I can use those receipts and pay myself back that $3k. It’s like having a special investment account that I can draw on anytime in the future when I need it. I love safety nets.

Long Term Care Self Insurance

a man in white shirt standing beside an elderly lying on the bed
Photo by Kampus Production on Pexels.com

One concern of many is the cost of long term care in our later years. It’s understandable as nursing homes can cost $100,000+ a year.

What if you saved diligently, didn’t spend that HSA and then let compounding do it’s thing? Say that a couple is able to save $100,000 in an HSA by the time they’re 50 years old and never contribute another dime. They pay out of pocket for expenses to do that.

If that $100,000 grows by 7% annually then when they hit 80 years old the accounts will be have $811,000! That’s a healthy balance to handle your long term care.

What if you don’t need that much money? Well, after age 65 you can withdraw HSA money penalty free and it’s taxed as ordinary income. Problem solved. Did I mention that it’s not subject to required minimum distributions (RMDs) either?

Use It To Cover Insurance Premiums

Maybe you aren’t worried about long term care but you are worried about other medical expenses in retirement. You can’t use an HSA for private healthcare insurance but you CAN use it for Medicare part B and D insurance after age 65.

Below are insurance options that DO qualify for HSA reimbursement. As always, these change over time so consult the IRS website for the latest rules.

  1. Long-term care insurance.
  2. Health care continuation coverage (such as coverage under COBRA).
  3. Health care coverage while receiving unemployment compensation under federal or state law.
  4. Medicare and other health care coverage if you were 65 or older (other than premiums for a Medicare supplemental policy, such as Medigap).

Action Steps:

  • If you have a HDHP and don’t have an HSA, open one!
  • Setup your account to contribute to it every paycheck. Even if it’s $10 a paycheck, get started.
  • Look into how much you need in your HSA to start investing.
  • Once you have enough to start investing, open an HSA investment account. Fidelity is one of the top providers.
  • Setup your HSA to autosweep funds to your investment account.
  • If available, setup your investment account to auto-invest the proceeds.

Additional Resources:

Like the content? Click here to subscribe to the e-mail list and have the articles delivered to your inbox.

Categories
Investing Taxes

What If The Backdoor Roth and Mega Backdoor Roth are Closed?

12/16/21 Update: Build Back Better Bill Senate voting pushed until early 2022. Backdoor Roths are safe for now! Check out my Mega Backdoor guide here.

11/19/21 Update: Build Back Better Bill passed the House with the changes to remove the backdoor Roth. We’ll have to wait and see if it can get through the senate. Personally, I’ve completed my MBR for the 2021 year and backdoor Roth conversions for both Mrs. MFI and I just to be safe.

11/8/21 Update: I jumped the gun a little with this article. It’s far from a done deal yet that these backdoors go away but still possible. I still think it’s prudent to take steps now to plan as if the backdoors do go away.

BLUF: Pending legislation would close the backdoor Roth and mega backdoor Roth contribution loopholes. There’s still time to take action for 2021 and good options for wealth building in 2022 and beyond.

There’s an old proverb that says that “all good things much come to an end.” I hate that proverb. Who wants something good to come to an end?

Unfortunately in this case one thing proposed to come to an end are the beloved backdoor Roth and mega backdoor Roth contributions.

If you’ve followed the blog you’ve read my extensive Mega Backdoor Roth article and know that I love and use that loophole.

I don’t read or watch the news as a practice to keep myself happier. However, being a personal finance nerd I did start to pay attention to the Build Back Better Bill discussion once they started talking about a variety of changes to the current retirement savings system that many of us use. We’ll know more soon but there likely won’t be much time to act if this bill passes.

What’s in there? What could come to an end are two sweet loopholes that allowed people to get money into Roth IRAs despite making too much income to contribute to them directly (the front door). In 2021 a single filer needed a MAGI of less than $140,000 and a married filing joint less than $208,000 to contribute to a Roth. What were these backdoor options?

Backdoor Roth IRA Contributions

The standard backdoor Roth IRA contribution was a two step way to bypass these income restrictions.

  1. Contribute to a traditional IRA (tIRA) with after tax money.
  2. Convert the tIRA money to a Roth account

Just that simple. Anyone can contribute to a tIRA regardless of income level, you just don’t get a tax break at a point. Since the money went into the tIRA after tax there’s no tax owed when that money is converted to a Roth account. The pro-rata rule made this impractical if you had other tIRAs with large pre-tax amounts in them but this was still a nice option for many that were otherwise locked out.

brown wooden opened door shed
Photo by Harrison Haines on Pexels.com

Mega Backdoor Roth IRA Contributions

The regular backdoor was great and all, but with contributions limited to $6k under 50 and $7k over 50 years old, it had limited savings potential. The mega backdoor however, blew the doors off of the regular backdoor.

If you had an employer retirement plan (401k/403b/TSP) that allowed after tax contributions and some other features then you could get $38,500 extra into your Roth. A year. It’s how I’ve been able to personally put $41,407 into my company 401k so far this year which is a combined total of pre-tax and after tax contributions. About $25,000 of that is after tax contributions ready to be rolled into a Roth via the mega backdoor.

If you want to read the fine details of how the mega backdoor Roth works you can read them here in my step by step guide.

Build Back Better Act – Slamming Shut The Backdoor

closed hanged on door
Photo by Kaique Rocha on Pexels.com

It’s amazing how much good you can undo with one simple sentence. As you can see below, the act kills the backdoor options by preventing after tax contributions to your qualified plans (401k, 403b, TSP, etc) from being converted to a Roth.

It also prohibits any after tax money in IRAs from being converted to a Roth. You can still contribute after tax money to IRAs (which now would make no sense) but the money can’t go to a Roth. All of this becomes effective on December 31st, 2021.

Source: House Committee on the Rules Summary

The wording seems unclear to me on exactly what they’re going to enforce. For example, are after tax contributions made in 2021 able to be converted to a Roth in 2022? Seems like I could interpret that in either way to allow them or not allow them.

Other retirement changes that are less likely to impact the less affluent investors:

  • In 2032 single filers over $400k in income and married filers over $450k in income won’t be able to do Roth conversions.
Source: House Committee on the Rules Summary page 170.
  • $10M cap on all retirement accounts. If the cap is exceeded the money in excess of $10M needs to come out.
  • You can’t contribute to a Roth or traditional IRA if your retirement account balances exceed $10M.
Source: House Committee on the Rules Summary page 169.

If you’d like to see it for yourself you can read the summary here. If you want to read the actual bill text you can find it here. Warning, it’s painful to interpret.

2021 Isn’t Over Yet – Take Advantage Of The Backdoor Roth Options

All of these backdoor benefits seem to go away at the end of the year but there’s still almost two months to go. As previously stated, it doesn’t seem clear to me if you’ll be able to convert 2021 after tax contributions over to a Roth in 2022 so I’m assuming for now that you can’t.

There’s still time to take one last advantage of these backdoors before they go away. Here are some options to consider if you have these backdoor options in process or available to you:

Do a Backdoor Roth Contribution from Scratch

There’s still time to do a backdoor Roth even if you haven’t done a thing this year. The basic steps:

  1. Open up a tIRA account immediately.
  2. Contribute the max ($6k or $7k depending on your age) to the tIRA.
  3. Wait a little bit of time. There’s no hard and fast rule here and it might not matter anymore but I would wait at least 2 weeks. This is to avoid the step transaction doctrine although I’m not sure how much that’s ever been enforced for backdoor contributions.
  4. Convert the tIRA money over to your Roth IRA.

Vanguard makes this conversion process very simple as they have “Convert to Roth IRA” link right on the balances and holdings webpage.

Complete Backdoor Roth Contributions

Same situation as above but perhaps you’ve made only some of your intended tIRA contributions for the year or you haven’t done the conversion step.

Complete Mega Backdoor Roth Contributions

You’ve got after tax money in your qualified retirement plan, get it into your Roth! Per the language in bill summary it says that after-tax contributions made after December 31, 2021 can’t be converted to a Roth. That implies that you might be able to complete the mega backdoor transfer in 2022 (or beyond) on those older 2021 and early after-tax contributions.

Personally, I’m not going to screw around with it and will be completely my mega contribution before the end of the year. The language seems open to interpretation and I don’t want to risk that money getting stuck because of it.

Follow my step by step guide if you aren’t sure how to do that.

Backdoor Roth and Mega backdoor Roth are Closed – Now What Do You Do?

Hopefully you’ve had a chance to breath deeply, calm yourself. Let the rage subside. Or…

Top 30 Computer Rage GIFs | Find the best GIF on Gfycat

I’m all about trying to stay level headed and focusing on what you can control. The bill has passed and what’s done is done. With those options closed, what options do we have to save and invest wisely towards FI? Let’s explore that once you buy a new keyboard and monitor.

Turn Off After Tax Contributions

This could apply to both your qualified plans (401k, etc) or your IRA but make sure that if you have some auto deductions / transfers in place that you turn them off by December 31st.

It sounds like these after tax contributions to retirement accounts will still be allowed in 2022 but I’m not sure why you’d want to do that. You have no tax advantages (after tax), your money is stuck in a retirement account (harder to access) and you can’t get it into a Roth.

It’s stuck there until you pull it out of your IRA one day (likely after 59.5 years old) where it’s going to be subject to the pro-rata rule. Any gains on your after-tax investments are considered pre-tax and are taxed as ordinary income.

Are Normal Roth Contributions (“Front Door”) Really Shut For You?

Nobody really calls regular contributions directly into a Roth as the front door method but that’s effectively what it is in relation to the backdoor options. To contribute directly to a Roth you need to have earned income and overall income that’s under the income limits.

For 2022 the income limits have been raised for those that want to make a standard Roth contribution:

  • Single Filer: Can contribute fully to a Roth at $129k or less of MAGI, fully phased out at $144k
  • Married Filing Jointly: Can contribute fully to a Roth at $204k or less of MAGI, fully phased out at $214k.

The important nuance here is that these limits are based on Roth Modified Adjusted Gross Income (MAGI) specifically. This gets very confusing because there are multiple formulas for determining MAGI so make sure you use the one specifically for the Roth.

The simplest ways to reduce your adjusted gross income and therefore your MAGI are to contribute to pre-tax savings accounts such as your qualified retirement account (401k, etc) and an HSA.

For example, for a married couple filing jointly in 2022 they’ll be able to contribute up to the following:

  • $20,500/ea in their 401k/403b/TSP = $41,000
  • $3,650/ea or $7,300 total as a family to HSAs

That means that they’d be able to make $252,300 together for 2022 and still be able to contribute the max each to a Roth IRA! $252,300 – $41,000 – $7,300 = $204,000 (Roth income limit). That’s the simple stuff. Capital losses can also reduce your AGI.

Looking at the Roth MAGI worksheet there are even more things that could reduce your income. Consult your tax professional if you need help planning and figuring out what’s possible for you.

Source: IRS Roth MAGI Worksheet

Invest in a Roth 401k/403b/TSP Instead

If your long term goals involve getting a money into a Roth then you should look into whether your employer offers a Roth option to their retirement plans.

Some let you split the money between plan types so that you could do $8,000 in a traditional 401k and $12,500 in a Roth 401k in 2022, for example. That could be a nice compromise if you want to invest some pre-tax and some post-tax. A Roth 401k would still be able to be rolled into a Roth IRA in the future.

Invest Using A Traditional Brokerage Account

It’s easy to get excited about all the different retirement accounts with special tax treatment and forget about the humble brokerage account!

Brokerage accounts are after tax investment accounts that are offered by a variety of different companies. Vanguard, Schwab, and Fidelity are the big ones but there are plenty of smaller new players such as M1 Fiance, Robinhood and Webull.

You invest in stocks, mutual funds, ETFs or crypto with your after tax money and when you sell those securities you pay taxes (booo). If you hold the security you buy for one year or less they are taxed as short term capital gains which are taxed as ordinary income. However, if you hold them for a year and a day or longer they get special long term capital gains tax treatment.

Magical Long Term Capital Gains

What’s magical you ask? Well if you’re married filling jointly it means that you can pay $0 in long term capital gains on all taxable income less than $80,800.

Investopedia: https://www.investopedia.com/articles/personal-finance/101515/comparing-longterm-vs-shortterm-capital-gain-tax-rates.asp

For example, let’s say that you invested through the years buying stock index funds for an average price of $100/share. Many years later you were able to sell those index funds for $500/share. That’s a $400/share capital gain when you sell it.

If you’re a married couple filling jointly with a standard deduction of $25,100 then how much in index funds could you sell and pay zero tax?

  • $25,100 standard deduction is taxed at 0% for long term capital gains (LTCG)
  • $80,800 is taxed at 0% for long term capital gains
  • $105,900 of LTGC’s are tax free for this couple.

However, that’s not what goes into their bank account. If they wanted to sell as much as possible and pay no tax they would sell $105,900 / $400 (gains/share) = 264 shares.

264 shares @ $500 (current price) /share = $132,000. Tax free.

The other key is that brokerage account funds can be accessed at any time. No special steps required to use that money before 59.5 years old.

Action Steps:

  • Make sure you take action on closing out any backdoor contributions for 2021.
  • If necessary, stop auto contributions of after tax money into your qualified retirement accounts and IRAs.
  • Check if you’re able to still contribute to a Roth directly.
  • Invest in other after tax vehicles like a brokerage account or real estate.

Like the content? Click here to subscribe to the e-mail list and have the articles delivered to your inbox.

Categories
Taxes

401k vs Brokerage Account: Which Wins when Income Taxes Rise?

aerospace engineering exploration launch
Photo by Pixabay on Pexels.com

BLUF: Income taxes will most likely rise in the future but 401k pre-tax investing net of taxes in this scenario still lasts longer than a brokerage account. Withdrawal needs in retirement would need to be high and taxation at or exceeding historical highs in the future for a brokerage account to catch up to a 401k.

Why I wrote this article

Pre-tax investing has always sounds like a great idea to me. I get to avoid paying paying Uncle Sam taxes from a high tax bracket now, let the money grow tax free and then pay income taxes from lower brackets in the future (because you will be drawing less from those accounts).

Then I listened to a podcast. I listened to an Afford Anything podcast with this guy Ed Slott who published a new book “The New Retirement Savings Timebomb.” Sounds big and scary, right? Well, Ed sure sold it that way. His premise is that tax rates are historically low now and are sure to go up in the future. Additionally, the (marginal) tax rates in the past have been as high as 90%. The horror! As such his advice was that young people should be putting 100% of their money into a Roth, NOT be doing any pre-tax investing.

That made my ears perk up. Anytime I hear personal finance advice that flies contrary to what I had thought I like to investigate it. This all sounded eerily like a scare tactic to sell his book but because I honestly never did the math of which accounts perform better with taxes factored in, I couldn’t be sure. In this post we’ll follow the hypothetical lives of two married couples to see how the Traditional 401k vs. Brokerage / Roth 401k could play out over a lifetime. Note that this entire post will use a married filing jointly example but the principles still apply to those in other filing situations.

Let’s talk taxes

This discussion requires a solid foundation in how the US tax system works so lets make sure that everyone is on the same page there. I know, talking taxes sounds about as exciting as going to the dentist. I’ll keep it brief!

How a progressive tax system works

In the United States we have a progressive tax system. The income that you earn starts out being taxed at a low rate and the taxation increases as you make more money. Each chunk of income that is taxed at a different rate is referred to as a tax bracket. $0 to $19,900 is a bracket of income that is taxed at the 10% rate in 2021 for married couples filing their taxes jointly. The next dollars you earn from $19,901 to $81,050 are taxed at 12% and so on.

These tax brackets are indexed to inflation from a law passed in 1984 meaning that the dollar amounts typically go up every year.

2021 Tax Rates and Brackets

How taxes are calculated

The most common mistake people make is thinking that the highest tax bracket that their money “touches” is the rate that ALL their money is taxed at. For example, if a couple makes $200,000 they think that their taxation is $200,000 * 24% = $48,000 which is wrong. This leads people to try and do silly things just to stay out of the next highest tax bracket when it doesn’t make much of a difference.

The table below shows how your taxes are actually calculated. If a couple makes $200,000 a year, the first thing that comes off the top is their $25,100 standard deduction. This is free income that is untaxed leaving the couple with $174,900 that is subject to taxation. Each bracket of income is then taxed at each tax rate and added up to a total tax. As you can see only the income above $172,750 is taxed at 24%. $2,150*24% = $516.

Tax calculation example for a 2021 married couple filing jointly

Take all those individual tax bracket amounts and sum them up and you get the total taxes that you owe. In this case $30,017 on an income of $200,000.

Marginal Tax Rate vs. Effective Tax Rate

The highest tax bracket that your money touches is called your marginal tax rate. In the previous example for a couple making $200k, that’s 24%. Since that is the marginal tax rate is thrown around sometimes people freak out and mentally use that number to calculate what they think they’re going to own.

In reality, what you actually owe in the end and what you should care about is your effective tax rate. This is the percentage of tax that you actually paid on the taxable income that you earned.

For example, this couple ended up owing $30,017 on an income of $200,000. $30,017/$200,000 = 15% effective tax rate. Sounds a lot better than 24%, doesn’t it? The problem is that marginal tax rates to figure out by glancing at a table while you need to calculate your effective tax rate taking a number of things about your tax situation into account. For that reason the marginal tax rate number will often be used in discussion. Now that you know what it means don’t let that trip you up!

Effective tax rate calculation

Taxes in the future

We do need to recognize that income taxes around 2020 are quite low. If no laws change, on January 1st, 2026 taxes brackets will reset from the Tax Cuts and Jobs Act (TCJA) of 2017 expiring with the following changes:

  • 12% tax rate goes back up to 15%
  • 22% tax rate goes back up to 25%
  • 24% tax rate goes back up to 28%[2]

Outside of that there is speculation that taxation increase will be required to pay for the massive money printing to recover from the pandemic. Going back to Ed Slotts’ comments when he said taxes have been as high as 90+%. He’s not wrong, but the comment is misleading and scary for the average person. In 1944 at the tail end of WW2, taxes for the highest (marginal) tax bracket were 94%![3] What he doesn’t mention is that it was for income exceeding $3 million in 2021 dollars. Allow me to get out my tiny violin for you if you’re crushing the game like that. The lowest bracket was 23% (still high) on up to ~$30k in 2021 dollars.[3]

Investment Account Taxation

To make sure that we’re on the same page with how taxation works with retirement and brokerage accounts lets review the topic.

Pre-Tax Accounts: 401k Investment Taxation

Using a 401k investment account means the money comes out of your paycheck tax free and reduces your taxable income. When you reach 59.5 years of age and withdraw the money it’s taxed as ordinary income just like a W2 paycheck today. Until you withdraw that money it’s allowed to grow tax free inside the 401k account. The near term benefit is that you save that money AND it reduces your tax bill.

The argument Ed Slott makes is that income taxes now are pretty low and they’ll be much higher in the future. You should pay those taxes today and put the money into a Roth 401k post-tax.

Post-Tax Accounts: Brokerage account & Roth 401k Investment Taxation

In this example I’m using a brokerage account because it’s accessible to many and allows you to contribute at least as much as the traditional 401k so we can compare apples to apples.

Brokerage Account:

A brokerage account is not a retirement account. Anyone can open one and the money simply goes in after all normal payroll taxes have been removed. You can then buy stocks, bonds and other alternative assets with those funds. If you sell assets within a year of buying them they’re called short term capital gains and are taxed as ordinary income. If you hold them for longer than a year then they’re taxed at a special, lower rate.

The 0% tax bracket is large enough that many couples in retirement can sell long term gains and pay no taxes. Unqualified dividends and bond interest is taxed differently but using your standard deduction that can be wiped away. The example below shows how a couple could withdraw $100,000 from a brokerage account in a year and pay $0 in tax.

Roth 401k:

Contributions to a Roth 401k have ordinary income taxes taken out of it first and then the money goes in after tax. The advantage is that when you withdraw the money there’s no tax to pay!

Case Study: 401k Fanatics vs. The Brokerage Buyers (or Roth 401k)

To see how a lifetime of saving, investing, withdrawals and taxation happens in an apples to apples comparison I give you the following scenario.

Overview

To make this fair they both have the same exact gross income and very high expenses (they aren’t good savers) every year. The 401k Fanatics max out their pre-tax 401k at $39k/yr and then are left with $0. The Brokerage Buyers followed Ed Slotts advice and paid the taxes first and contributed everything to a post-tax account. Because of that they are taxed more heavily on their income and have a smaller amount of post tax dollars to put into their brokerage account per year – $30,378.

401k Fanatics:

Below is what a typical year looks like for the 401k Fanatics.

Brokerage Buyers:

Below is what a typical year looks like for the Brokerage Buyers. With no pre-tax contributions they pay more in taxes up front and therefore have less money to invest in their brokerage account each year ($30,378) compared with the $39k/yr of the 401k Fanatics.

Assumptions:

  • Tax brackets – both couples incomes are taxed at 2021 tax levels through the accumulation phase. In the withdrawal phase we’ll vary the tax rates to see what happens.
  • Investments – both couples invest in the same low cost VTSAX index funds monthly. $3,250/mo for the 401k fanatics ($39,000/12) and $2,531.50/mo for the Brokerage Buyers ($30,378/12).
  • Investment returns – both couples get 7% average annual returns compounded monthly.
  • Brokerage account taxes – since income needs of the Brokerage Buyer couple are within the 2021 capital gains 0% bracket it is assumed that they pay no taxes upon withdrawal. For this reason the brokerage account is interchangeable with a Roth 401k for tax reasons in this example. They all pay $0 in tax when withdrawing. Any dividend or bond income is expected to be small enough to fall within the standard deduction.
  • Inflation – we’re going to use 2021 dollars all the way though the example. Expenses will rise with inflation but it is assumed to impact both couples the same.

15 Years of Saving and Investing Later…

How have our good little saving and investing couples done? Quite well! They started later in life at 45 years old and are now 60 after saving for 15 years. The 401k Fanatics are millionaires in the two comma club while the Brokerage Buyers have accumulated a healthy $807k in their brokerage account.

Retirement time! Who wins?

After 15 years of investing the couples have retired. They’ve paid off their house and cars and now only need $80k/yr to support their lifestyle. Let’s see what happens when the 401k Fanatics have to pay ordinary income tax on those withdrawals while the Brokerage Buyers get to laugh in the face of the tax man all the way to the bank!

Income taxes rise to 2026 levels

What happens if congress does nothing, the tax rates reset higher and that continues into the future? See below for the 2026 tax rate impact on our 401k Fanatics.

Hey now, what happened? The 401k Fanatics were able to make that money last almost 7 years longer than the Brokerage Buyers despite them paying 0% tax. Why? Well with the progressive tax brackets the 401k Fanatics are still only paying a 9.62% effective tax rate. Projected far into the future the Brokerage Buyers will still never catch them.

Income taxes rise to scary “2036” levels

Okay, maybe you believe that taxes will get much higher. After all, the fed has been printing money faster than Leonardo DiCaprio in Catch me if you can. I’m calling them “2036” tax brackets. What then?

The lowest rate becomes 15%, then 20% and increasing up to 70%! Yikes! That would be pretty bad.

Surely that must have tipped the scaled in favor of the Brokerage Buyers paying 0% tax? Well, nope. The 401k Fanatics effective tax rate went up to 13.5% and still get 4 more years of money than the Brokerage Buyers. Even projected far into the future they would never catch them.

The obvious next question that I had to answer was how bad would future tax rates have to get for these two couples to run out of money at the same time? Well pretty horrifically bad – I believe the worst in history even topping 1944 WW2 levels when the first bracket, $0 – $30k (inflation adjusted) was 23%![3] I had to come up with a 22.11% effective tax rate to make then break even.

What does that look like for tax brackets? I played with some numbers to come up with one potential. I thought that the “Doomsday” naming was appropriate.

Conclusions:

The big takeaway from this for me is that you really need to focus on effective tax rates when thinking about taxes in the future. Pre-tax money will always grow faster initially by comparison because you can simply save more of it. If you have really poor 401k investment options with high expense ratios that would certainly narrow the gap over but it’s situation dependent on how close the outcome would be.

The other observation is that the more you need to consume, the more of a tax penalty you pay and the more you need to worry about tax rates. I can’t imagine a world where the rich and poor pay a flat tax so the lower incomes will likely be taxed less. The less you can live on, the less you’ll be taxed.

Early Retirement Considerations:

Winning is great, but you don’t win if you can’t retire early because you can’t access the money. If you have an early retirement plan you do need to balance 401k investing with post-tax investing because having more money in a 401k doesn’t matter if you can’t access it when you need it.

Most people saving 50+% of their income can max out a 401k and contribute a substantial amount to a Roth and a brokerage account. That said, everyone’s situation is different and you need to plan out your investments to have the money you need, in the right buckets, at the right time.

Action Steps:

  1. Make sure you are investing in a 401k to get your employer match. That’s a 100% ROI!
  2. If you’re just starting out consider trying to maximize those pre-tax buckets.
  3. After that consider Roth IRA contributions.
  4. Build that brokerage account. Have you considered putting some of your emergency fund in there?
  5. If you plan to retire early, take a look at the different buckets of money. How much do you need to get to 60 years old to access retirement accounts? A detailed post coming on this topic.

Like the content? Click here to subscribe to the e-mail list and have the articles delivered to your inbox.

Sources

  1. TaxPolicyCenter.Org. https://www.taxpolicycenter.org/statistics/historical-average-federal-tax-rates-all-households. Accessed 4/17/2021.
  2. FedTaxPlanners.com. How 2026 Sunset Laws will impact your tax cuts. https://fedtaxplanners.com/how-2026-sunset-laws-impact-your-tax-cuts/ Accessed 4/17/2021.
  3. Tax Foundation Tax Rate History. https://files.taxfoundation.org/legacy/docs/fed_individual_rate_history_nominal.pdf. Accessed 4/17/2021.
Facebook
Twitter
Pinterest
fb-share-icon