Tax Advantaged Wealth Building – A simple guide
In working towards a goal of building wealth, there’s a few ways you can speed up your path to wealth – earning more through entrepreneurship, building higher valued skills, or taking on more risk with investments are all ways we can build wealth faster. However, one way that requires simply reallocating our money into different accounts, but lets us build wealth faster, is taking advantage of the numerous tax-free accounts that are available to investors. In America, the vast majority of investors have access to numerous tax-free accounts where they can store wealth for retirement and where it can grow tax free for years.
For example, if we assume a person invested $100,000 and held it for 40 years, and the investment produced an 8% annual return, and the person’s tax rate was 15%, they would end up with $2 million dollars in investments with a tax deferred account. But, if they invested with all the same assumptions, but simply invested it into a taxable account instead, they’d end up with $1.3 million dollars instead. Or in other words, they would have actually gotten a 6.8% return on their investments rather than an 8% return due to tax drag. Tax drags can be offset some by keeping track of cost basis and selling tax lots that are at a loss, but these only help so much as losses can only be tax deductible up to $3,000 for each year. But anything that exceeds a $3,000 capital loss can be carried over into the next year.
While losses are helpful in reducing capital gains taxes, they won’t help us build wealth. But as the above example illustrates, if you aren’t at least attempting to max out your tax advantaged accounts you’re going to be missing out on investment returns over the course of your lifetime – possibly by a few hundred thousand dollars. So I’ve created a quick guide to help people realize what accounts are out there and what the limits are.
Below is a picture on the steps you should take to getting the most out of your money. I’d print it off and hang it up near your computer or where ever you budget at as to make sure you’re following generally sound principles.
Emergency fund
The first and most important step is simply building an emergency fund for yourself and your family. The typical recommendation is having about 3-6 months of expenses in the emergency fund. This should serve as a buffer in case you are laid off or your there’s an unexpected expense. I go a bit further and do 6 months of expenses plus my health care deductible. I’m in a high deductible plan so I have a $3,000 deductible which I keep in my emergency fund as well.
401k –match your employers’ contribution
Next, if your company offers a 401k plan, invest up to the company match. So if your company, like mine, offers a 4% match, invest 4% of your income towards the company 401k. Do not leave free money on the table, period.
Reduce debt
Third, reduce any outstanding debt that you have. In my opinion, although there’s different schools of thought about debt, you should pay off the highest interest loans first, then work your way to the smallest interest loans. Your goal is to pay as little in interest as possible. But I realize it can be psychologically rewarding to pay off the small account balance (which could be either the lowest interest loan or highest interest). This is a personal decision and one that takes knowing yourself. I’ve found it helpful to map out the interest and principles of loans and then determine how much you’d be saving paying off the high interest ones first vs the lower interest ones.
IRAs – ROTH vs Traditional
For 2021, theirs is a total contribution limit into IRAs of $6,000. You can choose to split the $6,000 between the two accounts if you wish, or simply invest all $6,000 into whichever one you choose. If you haven’t decided on a Roth or Traditional the general idea is that, if you think your taxable income will be higher in retirement – choose a Roth IRA or if you think you’ll be paying more in taxes now choose a traditional. However, there are some additional benefits with a Roth IRA like being able to withdraw contributions without a penalty. But both traditional and Roths allow you to withdraw up to $10,000 for first time home ownership expenses. However, with a Roth, there are income limits if you’re a single tax filer you may be forced to contribute less than normal if you make over $198,000 (or $208k for married couples). Here’s a good rundown on the differences between the two accounts.
I choose a both a Roth and Traditional and I contribute the bulk of my $6,000 to the Roth and about $1,000 of the $6,000 to the traditional just to hedge my bets a little.
Health Savings Accounts
Many employers offer health insurance along with a host of other benefits you can choose from each year. If you elect to choose an employer provided insurance. If you choose a plan with an HSA attached to it you can invest pre-tax income into the health plan every pay check. The 2021 contribution limits are $3,600 for single filers and $7,200 for families. There are restrictions on these accounts like you can only use the contributions to pay for medical expenses. You can read more about the restrictions here. One word of advice, if you do plan to use your HSA as a retirement account, please keep careful record of your health expenses and try to pay most of them out of pocket in order to let your HSA grow. You can then use your out-of-pocket expenses to reimburse yourself when you retire. It’s a pretty high-powered Roth because your income goes in tax free and comes out tax free too – assuming you do it correctly. Not to mention, it helps build your health safety net in case something really terrible happens to you.
Company 401k
Once you max out your HSA (or if you just don’t have an HSA) then your next goal will be to max out or contribution more to your company 401k. Depending upon how much income you make, it may be difficult to max out your 401k if you’re following my guide. Obviously, your goal should be to max it out but if you aren’t able to, simply raising the percentage that gets taken out every paycheck is a great idea. And then decide if you have any other savings goals in mind.
Taxable accounts
Last but not least are taxable accounts. These I would say you should use last or use if you have savings goals that are 5-10 years out and you want to save towards those goals but don’t want the incredibly low interest rates that high yield savings accounts are providing right now. I personally am in this exact position, I’ve maxed out my Roth, HSA, and I’m on track to max out my 401k and I’m now using my taxable accounts to build towards buying a used car in about 7 years and putting a down payment on a house in about 5-8 years. But I would rather take market risk than put those amounts into a HYSA.
Other possible accounts for you to use:
There’s various other accounts out there like FSA (more health plans), 529 college savings plan, 403 plans (401ks but for self-employed folks), 457 plans (like 401k but for government employees), and a few others.
Summary:
Now, let’s say you have followed my above plan for yourself and you’re a single person, you will have invested $29,100 (401k – assuming no match, HSA, and IRA are all maxed out for the year). Investing $29,100 every year for 40 years with a modest 7% rate of return will give you $5.8 million dollars of tax-free earnings upon retirement. Your total contributions will have been $1.1 million dollars and the interest will have been $4.6 million. That is a healthy amount to retire on by any standard.
Now there are plenty of brokers out there to take care of your assets but I think M1 Finance is a really great broker. If you start a IRA with M1 Finance by putting $500 dollars in or $100 with a taxable account they’ll give you an extra $30 dollars when you use my referral link. Not to mention, if you get M1 plus you’ll get 1% APY checking (I use it as a high yield savings account – there’s few banks giving out rates that good anymore) and you can borrow against your investments at only 2% interest, which I think is also about the best deal, Interactive Brokers has a slightly better deal at 1.5% last time I checked. But if you’re just starting out you should learn about asset allocation, feel free to check out that post, here. And finally, if you’re looking for further ways to enhance returns check out our high risk and ultra-high risk newsletter.
Note: the M1 referral link gives the reader $10 extra dollars to invest with if they choose to fund a taxable with $100 dollars within 30 days of opening the account or fund an IRA with $500 within 30 days of opening an account. The author of this article will receive a $10 dollar compensation as a result of the reader opening an account. The compensation for both parties occurs 30 days after the deposit occurs and assumes the full amount is retained in the account until the end of 30 days from the deposit day. The author uses and endorses M1 Finance. The link to M1 finance is a referral link. The $30 dollar referral lasts until M1 stops offering it.
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