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2020/08/18

Investing in All Tax-Advantaged Accounts

Why invest in tax-advantaged accounts?

There are not many high-yielding investment gains that are guaranteed. The U.S. government has laws that allow for a variety of ways to pay less tax on the money you save. These laws encourage saving for retirement, saving for health expenses, and saving for education expenses. Taking advantage of these laws allows for reductions of taxes. This saved money from paying less tax is extra return (of up to over 100%) on almost any investment.

Preliminary Warning

The advice here is for extra money that is left over after expenses have been paid. If there are high interest debts or other immediate obligations, those should be taken care of before investing for the future.

How?

There's an order of operations to investing that allows for the most efficient use of limited income. Not all accounts are giving the same tax benefits. Before you have an income that can max out all tax advantaged accounts, you'll have to prioritize. Here is how I prioritize investing in tax-advantaged accounts.

1. Invest to the 401k/403b/457b/SIMPLE IRA/SEP match.
   1. This is a guaranteed 50-100% return. This cannot be beaten.
2. HSA (Health Savings Account) if eligible
   1. This account is triple tax-advantaged.
3. Contribute to the maximum for traditional 401k
   1. Contributing to traditional 401k reduces taxes from the top income tax bracket, letting you draw in money to your bottom income brackets during retirement. This is trading paying up to 37% (or more with state) taxes for paying down to 0%.
4. (Backdoor) Roth IRA or Traditional IRA
   1. I would favor the Roth IRA, but if your income will never be higher than the contribution limits to Roth IRA, you may decide on traditional.
      1. The reason for this is because of the pro-rata rule. If you have pre-tax money in your traditional IRA while trying to contribute to your Roth via the "Backdoor Roth" method, you'll invoke extra taxes.
      2. If you do end up having money in a traditional IRA pre-tax and want to clean the space for backdoor Roth IRA, see if your employer allows a traditional IRA rollover into your traditional 401k.
5. After-tax 401k
   1. If you're allowed aftertax 401k contributions and rollovers into Roth401k/RothIRA, this is the mega backdoor Roth. 
6. 529 Plan (Educational Account)
   1. If you need to save for educational expenses, this account is valuable. If not, just invest in taxable instead.
7. Taxable

Why Do I Favor This Prioritization?

401k

Investing pre-tax dollars moves money from where it would be taxed the most, to where it will be taxed the least. Investing in a traditional 401k reduces your tax liability from your top bracket. If you're in the 24% marginal bracket, every dollar you invest pre-tax is reducing your tax burden by 24 cents. In the future when you're withdrawing from this account, it will fill your income, which is probably not much in retirement. As it fills up your income, it starts in the lowest brackets first. Your effective tax rate is reduced substantially in this manner. There is the argument that tax rates will raise in the future, so that's where the tax-liability diversification of the Roth IRA comes in.

HSA

This account is the only account that provides the 3 forms of tax reduction. There are no taxes on contribution, on gains, or on withdrawals. It can only be used for health expenses until the age of 65 when it can be used like a normal retirement account. If you withdraw for expenses other than medical expenses after 65, then it will be taxed like a Traditional IRA/401k.

Roth IRA

If you're a high earner, using a backdoor Roth strategy is your best way to invest your money in a tax advantaged way after Traditional 401k and HSA. Roth IRA's contributions can be withdrawn before retirement penalty-free. Roth IRA's conversions can be withdrawn 5 years after the conversion penalty-free. This account provides a way to access retirement money penalty free if you want it before 59.5 years of age.

After Tax 401k/IRA

This is just a manner to get more money into your Roth IRA/401k. If you're going to save that money, it's better to get the extra tax advantages that you can.

529 Plan

529's offer tax advantages similar to a Roth IRA, but can only be withdrawn for educational expenses without penalty. If you're going to spend money on educational expenses, you might as well enjoy the tax benefits for saving for it.

Taxable

Taxable is the only account that doesn't have restrictions on use. The drawback is it doesn't have any tax advantages. A taxable account is important for tax-diversification of investments as well. If you need to save money for something before retirement (like a downpayment on a house), you can use this account to pay for it.

Contribution Limits

IRS defines the contribution limits which will change through the years.

https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-contributions

If you can get $66,550 (401k $57,000, IRA $6,000, HSA $3,550) invested into tax advantaged accounts each year as a single person, you're in a good spot.

If you're more of a visual person, I made a graph that shows every tax advantaged account your money should go on your paycheck. If you don't have a 401k, use the equivalent.

Figure 1. Paycheck pathing

Example of How to Earn $76,000 Easily

Taxable Example

Alternative title: How to Make $76,000 by Knowing Tax Code

To convince you that tax-advantaged accounts are a good return on investment, let's walk through an example.

We have a person who makes $150,000 pre-tax per year, is single, and under the age of 50. I use a high income to allow for the effect of using all tax-advantage space to be seen. They live in a income tax free state. They spend $50,000 this year, but they don't decide to take advantage of any forms of tax-advantaged space they can in a year. Smartly, they decide to invest the left-over money they made.

Figure 2. Income After Taxes With no Tax Advantaged Investing

Formula and assumptions

They are left with $112,339 to spend, of which they spend $50,000. This leaves $62,339 left to invest, all in taxable.

Returns are 6%/yr, with dividends returning 2%, and inflation is 2%. The formula used to calculate the return on this investment is as shown:

Figure 3. Formulas for return with 15% dividend tax

Where P_n is the current year's end principal, and P_{n-1} is the previous year's end principal. Why is the return not 1.06%? 0.3% is lost to taxes on qualified dividends (15%), and 2.1% is lost to inflation.

After 30 years of 6% annual returns, their investment will grow to a real (non-inflated) value of $301,724.27. They spent $13,756.38 in taxes on dividends. Capital gains will be owed on $239,385 of the investment if sold. After capital gains tax of 15%, the investor is left with $265,816.48 in spendable cash. They pay $35,908 in capital gains if they liquidate their position.

Tax-Advantaged Example

We have the same person who makes $150,000 pre-tax per year, is single, and under the age of 50. They still live in a income tax free state. They spend $50,000 this year, and they decide to take advantage of all forms of tax-advantaged space they can in a year. Smartly, they decide to invest the left-over money they made as well.

Figure 4. Income After Taxes With All Tax Advantaged Investing

After investing in the 401k for $19,500 and the HSA for $3,550, they pay $32,078 in income taxes. They have a take-home of $94,872. They spend $50,000 and have $44,872 left for further investments. Their 401k gets a 2% match from the employer, so they have $22,500 in their 401k before investing after-tax. Their employer also matches a $500 payment to their HSA. They take advantage of the Backdoor Roth IRA ($6,000) and the Mega Backdoor Roth IRA, called After-tax 401k ($34,500). Finally, they invest what's left, $4,372, in a taxable account.

At the end of the first year, ignoring intra-year growth, their accounts look like this:

After the same 30 years of returns as before, the accounts grow to the following:

We paid capital gains taxes on the Taxable account ($2,518.31) and taxes on dividends ($964.77). On the Traditional 401k balance, we paid income tax ($28,609). The other accounts do not owe taxes on gains or final balance. The final result: 

• We invested more by virtue of payable less tax in the first year and by taking advantage of our employer benefits.
• We paid less tax by a substantial margin
• This decreased tax drag allowed our gains to compound faster, which would continue to outpace the taxable investments even quicker if left to grow
• We earned $76,000 more money that can be spent.

Conclusion

There are many ways to invest for the future and opportunities offered for these investments. Taking advantage of all that you can gives you large, guaranteed returns just for a little planning. The benefit of the diversification of tax liability gives you freedom to save money in a risk-free return way.