My investing strategy part 3

Taxes are probably the most important part of your retirement plan. Your tax strategy is possibly even more important than your asset allocation and like the asset allocation, there is no one size fits all approach. There is however a relatively similar path that most people should follow in order to maximize their returns and minimize their tax impact. The below lays out how you should be investing your money in order to do just that. There are exceptions to the below rules but we’ll talk about those later.

Note that I do not mention a savings account in the below strategy. However, I am a firm believer that you should keep 4-6 months living expenses in a safe savings account that you can access at any time. Job loss and unforeseen expenses happen and you’ll be glad to have that buffer when they do and you won’t have to liquidate any of your stock position creating taxable gains or potentially selling during a down turn.

The tax efficient strategy playbook
1. 401k/403b up to employer match
2. Pay off any high interest debt
3. Max out HSA
4. Max your 401k, Roth IRA or Traditional IRA depending on tax strategy
5. Taxable account with tax efficient selections
That has essentially been my strategy since I started and it is the one recommended by most because it maximizes your tax advantaged accounts which in turn maximizes your future returns. In addition, it allows you the most flexibility when it comes to being in control of your own taxes which we’ll discuss later. But first let’s go through each step and discuss why it makes sense to prioritize that step over another and in which situations it makes sense to ignore the playbook.
401k/403b up to employer match
Step 1 is simple. If your employer offers a match then you’re effectively getting free money or a guaranteed 100% return on your investment. There is no investment anywhere that will guarantee anywhere close to that kind of return. There are really no exceptions to this rule aside from situations where your employer has a very long vesting period and a terrible fund selection. If as an example, your current employer offers a 3% match but it vests after five years and you don’t plan to stay there for five years then there’s really no benefit to be gained from the match and you can focus on paying off debts before going back to the playbook rotation.
Pay off any high interest debt
Step 2 is a bit more difficult since defining high interest debts is more of a personal question. Let’s assume an expected long term return on stocks of about 7%. It makes no sense to invest in stocks if you have debt that is greater than 7% because you’ll be losing more than you stand to gain. In that case, you should definitely pay off any debts before you invest in stocks beyond the employer match. If the interest rate on the debt is below that level then you have a decision to make as you can potentially gain more by holding off on paying the debt and investing in stocks instead. However, the risk there is that the 7% is not a guaranteed return while paying off your debt is a guaranteed return of X% where X is the interest rate so this decision comes down to your risk tolerance. For the most part, I try to carry no debt beyond a car payment or a mortgage. I use credit cards but always pay them off before the end of the month and try to take advantage of low interest rates(<2% for cars, etc.) whenever possible. I went to a cheap local school and worked through college to pay the bills so I had no college loans but for most people that is what they’ll be dealing with here. If your college loans are in the 4-7% range then I’d still consider concentrating on those before investing heavily in the market. If they’re higher then definitely tackle those first before moving on to investing.
Max out HSA
Step 3 only applies if you have a high deductible health plan that pairs with an HSA. An HSA isn’t something that’s available to everyone but it offers some great tax benefits to those who can take advantage of it. The first thing that matter is that the HSA can be moved with you if you change jobs although you may have to find a new HSA administrator if that happens. .
The second great thing about HSAs for those that have an offering through their employees and contribute through a payroll deduction is that those contributions are not only exempt from taxes but also from FICA taxes. That’s a 7.65% savings on the HSA contributions if contribute as a payroll deduction. That’s a big deal. Unfortunately, if you don’t take this as a payroll deduction but as a lump sum contribution via your HSA bank then you don’t get that benefit.
The third great thing about HSAs is that they can effectively be used as a tax free haven. First, contributions are tax-deductible for both state and local taxes. You also get the FICA benefit if you contribute via a cafeteria plan payroll deduction through your employer. Secondly and importantly, the withdrawals are also tax free if used for qualified medical expenses and as of right now, you can reimburse expenses accrued in an earlier year as long as they were paid after the HSA was established. That means that technically I can pay a bill out of pocket now, enjoy the tax free growth of an HSA for ten years and then withdraw money to offset that bill ten years from now and use that money for other things.
This requires proper record keeping but it allows for a more flexibility around withdrawals as one of the downsides of an HSA is that withdrawals for anything other than medical expenses are taxed at your full tax rate plus a 20% penalty. The good news is that the penalty disappears after you’re 65 or disabled so then it effectively becomes another retirement account.
The problem with HSAs is that tax free withdrawals only work for medical expenses. However, medical expenses will likely be a good portion of your spend in your later years so it’s not like the money is wasted. With proper record keeping, you can also use medical spend in current years to offset tax free withdrawals that you can then spend on other things. This is helpful if your goal is early retirement as otherwise, this account is essentially only for medical spend until you’re 65 which is still valuable but a bit less so than the other retirement plans which don’t have that limitation. Still, even if you don’t plan to use it as anything but a medical expense account and then additional funds once you turn 65, it’s still worth maxing out an HSA because of the tax free growth and the ability to save on FICA taxes if contributions are done through a cafeteria plan.
The one thing to consider with HSAs is that using them as a retirement vehicle is only as good as the funds available in your HSA. Some HSAs only allow investments in a low interesting savings account. That means you get tax savings and tax free growth but at a 1% return, that’s pointless if that’s all that’s available to you through your employer and you plan to stay there for a long time. If that is the case but you plan to leave soon then it’s still worth putting money in there because you can move your money to another low-fee administrator that offers low cost mutual funds once you leave. Another thing to keep in mind is that some employers and HSA administrators will force you to keep a certain amount in your HSA account and only allow you to invest funds beyond that point in mutual funds so if you’re just starting an HSA, be aware that you might not have access to mutual funds in your HSA immediately.
In my case, my employer requires a 2k minimum in your HSA cash account and allows the excess to be transferred to the HSA investment account which luckily offers low cost mutual funds including vanguard index funds and no additional fees so I always max out my HSA to take advantage of all the benefits I mentioned. There are some HSA administrators that do charge some additional fees(monthly fees, etc.) so keep an eye out on what your HSA costs and investment options might be before making a decision to investing in an HSA.
Personally, I don’t save my medical receipts and view the HSA more like an IRA that I won’t have access to until I turn 65. It’s not the ideal early retirement vehicle but it is one I use anyway because of all the benefits it offers plus the fact that medical expenses will likely make up a good portion of my overall spend as I get older and older so it’s likely that’ll I get the withdrawals at a tax free rate for at least a portion of my HSA savings. Even if I don’t then I’ll still have the tax benefits on the front end and will be able to use it like a 401k on the back end.
There are two risks I see with HSAs going forward. One is that the ability to reimburse yourself for expenses in the past will disappear which makes it less desirable for those seeking an early retirement path(although you’ll still need money after you turn 65 and this’ll still be there for you then). Another is that the high medical cost inflation and chronic under-insurance will eventually hit a point where the only logical solution is a socialized system and that puts a savings account like this whose main goal is to spend on medical expenses in question. What will happen to HSAs in a situation like that is unclear but I don’t see that as a major concern going forward.
So basically, general rule in my mind is that if you have a cheap low fee HSA offering that has access to low cost mutual funds then you should max it out especially if those contributions can be done through your employers cafeteria plan because the added benefit of FICA savings itself is worth it.
Max your 401k, Roth IRA or Traditional IRA depending on tax strategy

What makes tax-advantaged accounts like the HSA, ROTH, Traditional IRA and the 401k so great is that they allow you to have a ton of flexibility around your current and future tax planning.

This all comes down to how our tax system is currently structured. For simplicity’s sake, I’m using values of a single filer with the below adjusted gross income before 401k/Trad IRA deductions.

Under our current system, the first dollar you earn is taxed at a lower rate than the last dollar you earn. If I make $50000/yr, that puts me in the 25% marginal tax rate bracket but that doesn’t mean I pay 25% of that in taxes. For 2016, I would pay 10% on the first $9275, 15% on the next $28375 and 25% on the next $53500 and that continues until we reach the final tax bracket of 39.6% for any income of $415051. Now why does that matter? It matters because we can take advantage of this system to maximize our savings potential and minimize taxes paid.

What makes these tax-advantaged accounts like the 401k so good is that the dollars you invest in your 401k are the last dollars you earned which means they are taxed at your highest marginal tax rate. This can be as high as 39.6% depending on how much you make and this number plays a big role in answering the question of whether or not the Roth or Traditional options are better for you.

The Roth IRA or Roth 401k if offered doesn’t offer that same tax-savings but does offer the benefit of being tax free upon withdrawal. This makes it a better option if you think that you’ll end up buying a higher tax rate in retirement but what are the odds of that happening?

Let me use myself as an example. I make less than the $91000 needed to put me in the 28% marginal tax rate so if I use a 401k or traditional IRA, I’ll save 25% on each dollar put into the 401k. If those contributions were to bring me below the 25% marginal tax rate line, I’ll save 15% on the additional dollars in that range. In my case they do not so for every dollar I put into my 401k or traditional IRA, I save 25% by deferring taxes until retirement.

In order for a Roth IRA to make sense for me, I’d have to have an effective tax rate of 25% or higher in retirement. Now how likely is that to happen? Remember that we’re in a marginal tax rate system which means that the first dollar is taxed at a lower rate than the next dollar assuming that dollar brings it into a new tax bracket. 401k/Trad IRA distributions are handled like regular income so that means that if I were to retire today, I’d pay 10% on the first $9275, 15% on the next $28375, etc. until we reach my actual income. If I want to get an income of 80k, I’d be paying an effective tax rate of
19.7% which is quite nice considering I saved 25% on the front end when I put the money in and will only pay 19.7% on the back end when I take it out.

To reach an effective tax rate of 25%, assuming no other earnings, I’d have to take out over $190000. That’s quite a jump in earnings if I want to have the same 25% tax savings on the back end. Now this is obviously a best case scenario type of thing as my 401k withdrawals could and will be subsidizing income from other sources like social security and pensions and as such could be taxed at a higher marginal tax rate but it does serve to illustrate that sometimes a Roth IRA just isn’t that great.

This is not to say that you should always choose a traditional IRA over a Roth because that’s not the case either. The Roth IRA is a bit more flexible allowing for things like removing your contributions(not earnings) without penalties which can be nice. A Roth IRA is also a better tool for estate planning(if you plan to pass the money on to your kids) as it is not subject to required minimum distributions like an IRA can add a good deal of value in continued tax-free growth. Also, since the 401k saves you money on the last dollar earned, it may also make sense to choose a Roth if your last dollar is earned in the 15% or lower tax bracket since it’s quite possible your taxes in retirement would be higher.

Another factor will be your income. Note that if you are covered by a retirement plan at work then the deduction you get for a traditional IRA begins to phase out at modified AGI of 61k and is completely gone at modified AGI of 71k. If you make above that level then the Roth is naturally a better option.

The other and more important factor that may drive you to choose a Roth over a traditional IRA is that it provides a level of diversification when it comes to taxes. The numbers I used above to illustrate my point are based on 2016 tax tables. Let’s say that instead of retiring in 2016, I choose to retire in 2026 and look at the tax tables then. What if the bottom marginal tax rate is now 25% and the top is 75%? I’d have saved 25% on the front end and have to pay an illustrative 35% on the back end because taxes have gone up as they so often do these days. Another example might be an increase in income/living expenses. What if I earn $80000 this year making my marginal tax rate 25% but retire in a much more expensive area and require $400000/yr to live making my effective tax rate greater than 25%. In both of these situations or a combination of both, a Roth IRA would have likely been a better idea which is why I actually do have a Roth IRA instead of a Traditional IRA even though I don’t believe the current tax climate really makes it all that enticing. I do it because I think there are future uncertainties around the tax code that may mean I’ll be in a higher effective tax bracket when I retire than the marginal tax rate I am in now.

That’s why my retirement plan has a combination of the standard 401k and HSA which have front end tax advantaged savings and the Roth IRA which has a back end benefit.

In my case, I max the 401k then do the Roth IRA. I do have access to a Roth 401k at work but I like the guaranteed 25% tax savings over the potential for higher tax savings in the future. If taxes do go up and brackets change in an unfavorable way, I do have the Roth IRA to take some of that sting off the back end.

What’s nice about the 401k and Roth IRA setup is that even if taxes do go up, you can still have some control over your effective tax rate since you can take 401k distributions up to a certain marginal tax bracket(let’s say 25%) then take the Roth IRA distributions tax free after that.

Now the problem some will have in this scenario is that a lot of these accounts are retirement accounts to be used after a certain age which is generally long past a person’s ideal early retirement age. There are ways around that which I plan to utilize like Roth IRA conversion ladders and 72(t) early distributions but it also helps to have an account you can access at any time without penalty to help buffer the years between early retirement and what the IRS considers retirement. That’s where taxable accounts come into play. Tax-advantaged accounts which allow you to reduce your tax burden and therefore invest more are certainly the first line of investing but it helps to combine them with taxable accounts when talking about early retirement. The rules around early withdrawals, whether through early distributions or conversions are complex so it can help to have some taxable accounts with no rules around access before you get your conversions/early distributions ironed out.

Taxable account with tax efficient selections

This is your standard brokerage account. You invest after-tax money and pay taxes on any gains and dividends in these accounts. As such they don’t grow as fast as a tax-advantaged account and you’re also putting in after tax money here so the amount of money you can invest is less than what you put into your 401k.

In my case, I have two broker accounts, one through my employer for the employee stock purchase plan and one through vanguard for access to their ETFs.

The most important thing when it comes to taxable accounts is tax management and that is one of the most important things when it comes to overall return and one of the things that will likely sink most individual investors when it comes to their returns versus the marketplace.

Since this post has gotten a bit long, I’ll talk about exactly what I do when it comes to taxable accounts in another post. The main idea is proper security placement within your tax-advantaged accounts and your taxable accounts and a long term plan in your taxable accounts to qualify for the long term capital gain tax rates.

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