FI Step By Step: Step 9, Maximize Your Tax Advantaged Accounts

Step 9, Maximize Your Tax Advantaged Accounts

Taxes are the single largest expense for most Americans.  So, in your pursuit of FI, minimizing your overall tax burden should be a key part of your winning strategy.  One way to do this is to maximize your contributions to tax advantaged accounts.  

This is Step 9 of my FI Step By Step Series of blog posts.  Before we discuss how to maximize your tax advantaged accounts, let’s review the steps you should have already taken before moving on.

At this point you should have defined for yourself the reasons you want to pursue financial independence.  You should know your net worth and regularly be tracking your income and expenses.  You should have a written financial plan that you refer to regularly and update as needed.  You should have adequate insurance in place for your given situation, as well as an emergency fund.  If you are an employee, you should be maximizing your employer benefits, including contributing the necessary amount to your 401(k) to get the full employer match.  And finally, you should have paid off all of your debts with the exception of your home mortgage.  If you have completed all of these things, it is time to move forward with Step 9 and maximize your tax advantaged accounts.  

If you haven’t completed all of these steps, I would hold on trying to maximize your contributions to tax advantaged accounts.  For example, if you don’t have an adequate emergency fund, it doesn’t make much sense to contribute all you can to your retirement accounts.  If there is an emergency and you need access to your money in these accounts, you would typically have to pay taxes AND a 10% penalty just to get to your money.  Likewise, if you don’t have life insurance in place and are involved in a tragic accident, the money in your 401(k) at this point will likely not be enough to support your family.  And if you still have significant consumer debt at 15% interest or more, it makes little sense to contribute your excess money to a retirement account (where you hope to average an 8% return) when that money could be used to pay off your high interest debt.  For all these reasons and more, don’t move forward on Step 9 until you are ready.

Disclaimer: Please remember that I am not a financial professional. This blog post is for informational and entertainment purposes only.  Please consult a financial planner, financial advisor, certified public accountant, or other financial professional before making decisions regarding your retirement and finances.

Why Maximize Tax Advantaged Accounts?

As I discussed above, at this point, you should have all of your debts paid off.  You should be living beneath your means, which means you spend less than you earn.  So what should you do with that extra money?  

As I’ve mentioned before, there are really only four things you can do with your money.  You can spend it.  You can give it away.  You can simply save it.  Or you can invest it.  At this point we’ll assume you have already met all of your expenses and contributed your desired amount to charitable giving.  So that leaves us with two options.  You can simply save it, or you can invest it.  

Above and beyond your emergency fund, and perhaps a small cash cushion, I wouldn’t recommend just saving your money.  If all you did with your excess income was put it into a savings account, even a high yield savings account, the interest rates are so low that they don’t even keep up with inflation.  So not only is your money not significantly growing, it is actually losing value.  So really, the smartest thing to do at this point is invest it.  Of course there is some risk that comes with investing, but there are a number of strategies to minimize that risk, including investing for the long term and diversification.  

Assuming you are going to invest this extra money, you want to maximize your returns, right?  Here are three ways tax advantaged accounts can help you get the most out of your investments.  

First, you want to be able to put in as much money as possible.  The more you invest, the more it can grow.  Many tax advantaged accounts allow you to invest pre-tax dollars.  This means that you don’t have to pay taxes now on the money invested.  By avoiding taxes now, you can invest more of your money, which can increase your return.  But be aware that taxes will be due for most of these types of accounts when the money is withdrawn.  

Second, you don’t want anything draining your money while it is invested.  The more of your money that can stay invested, the more it can grow.  Most tax advantaged accounts allow your money to grow tax free.  This means you aren’t required to pay taxes now on any dividends or interest earned from your investments, allowing all of that money to be reinvested.  Likewise, when you rebalance or change investments within a taxable account, so long as the money stays in the account, any capital gains are not taxed now either.  Contrast this with a taxable investment account, where each year where dividends paid out, interest earned, and realized capital gains are taxed.  

Third, you want to keep as much of your money as possible when you finally take it out.  Some tax advantaged accounts allow you to withdraw your money tax free, which means more money for you.  Again, contrast this with a taxable investment account, where any assets you sell for a profit are capital gains, and are taxed.  

Hopefully you can see why tax advantaged accounts can be so powerful.  They help you make the most of your money by reducing the amount of taxes you have to pay on your investments.  So the best course of action, once your financial house is in order, is to fill these tax advantaged buckets as much as you can before you start investing elsewhere.

What Are Tax Advantaged Accounts?

As the name implies, tax advantaged accounts are those that give you some form of tax benefit.  The majority of these accounts are for retirement.  These accounts generally fall into one of two categories, pre-tax and post-tax. Let’s briefly review what this means.

There are generally three phases in which these accounts can give you a tax advantage.  As I alluded to above, they can help you save you on taxes up front, taxes as your money grows, or taxes when you take distributions.  Most tax advantaged accounts will help you with two out of these three phases.  

Pre-tax accounts allow you to avoid paying taxes now on the money contributed, as well as defer any taxes on the money as it grows.  However, taxes are due when the money is distributed.  That is why these are often referred to as tax deferred accounts.  Some of the most common pre-tax accounts are the 401(k), 403(b), and traditional IRA.  

Post-tax accounts require you to pay taxes up front.  However, the money can then grow tax free, as well as be withdrawn tax free (so long as you follow the IRS rules for distribution).  The most common post-tax account is the Roth IRA.  In addition, most employer sponsored retirement plans these days will also allow you to make Roth contributions to your 401(k) or 403(b), essentially changing these to post-tax accounts (at least the portion of the account holding post-tax contributions).  

The one exception to the “two out of three” rule of thumb for tax advantaged accounts is the Health Savings Account (HSA).  With an HSA you can contribute pre-tax money, that money grows tax free, and it can be withdrawn tax free so long as it is used for qualifying medical expenses.  It is the only triple advantaged account.  You can read more about HSA’s in my post Do You Have The Ultimate Retirement Account? Part 1 and Part 2.

Another tax advantaged account is a 529 plan for college savings.  While these plans don’t give you a federal tax break up front, they may reduce your taxable income on your state tax return, depending on your state.  However, regardless of what state you are in, once money is contributed, it grows tax free (federal and state) and is distributed tax free so long as it is used for qualifying educational expenses.  

While I can’t list all of the possible tax advantaged accounts, these are the basic categories they fall into and some of their most common examples.  For a more comprehensive review of retirement plans and accounts, please see my posts Top Ten Terms You Should Know About Retirement Plans & Accounts Part 1, Part 2, and Part 3.  

How Should I Prioritize These Accounts?

OK, that makes sense, but which account or accounts should I try to maximize first?  Good question.  I understand that not everyone can max out every tax advantaged account right away, so which accounts should have the highest priority?  In essence, we are asking in what order should you fill these buckets?

This is a complex question and depends on a large number of factors including your income, what accounts are available to you, personal/family situation, short term, intermediate, and long term financial goals, time horizon, outlook for the future, and retirement plans.  This is where a good financial planner or advisor can be well worth their cost (which should be a fee only advisor).  

Most everyone would agree, the first thing you should do is contribute the necessary amount to your employer sponsored retirement plan (usually 401(k) or 403(b)) to get the full employer match if this is available to you.  As we discussed in Step 7: Maximize Your Employment Benefits, this is free money that you don’t want to leave on the table.  

After this point, however, there are some varying opinions on what bucket you should try to fill next.  The main question is should you fill your pre-tax or post-tax buckets first?

In the general personal finance world, the standard advice is to base this decision on when you think you will have a higher income, now or in retirement. If you think your income is higher now than it will be in retirement, fill you pre-tax buckets first.  This will allow you to avoid taxes now while you are in a higher tax bracket and pay them later in a lower tax bracket.  Conversely, if you think your income will be higher in retirement that it is now, then fill your post-tax buckets first while your tax bracket is lower so you can withdraw the money tax free when you are in a higher tax bracket.  The problem with this approach is that you really don’t know with any certainty what your income will be in retirement.  Furthermore, we can’t know with any certainty what tax rates will be in the future.  

In the FI community, the standard advice is different.  Most proponents of FIRE would recommend you max out your pre-tax accounts first.  This is especially true for high income earners, but this advice can generally be applied to most people.  There are at least two reasons this is typically recommended.  

First, you are getting a guaranteed tax benefit today.  It’s the financial version of “one in the hand is worth two in the bush.”  As I just stated, we don’t know what the future will bring.  What will your income be in retirement?  What will taxes be in the future?  Will the rules for these accounts change with new legislation?  There are just too many variables that could reduce or negate your tax benefits in the future.  But if you fill your pre-tax buckets first, you are guaranteeing that you get that tax benefit today.  

Second, numerous strategies exist for minimizing taxes on the back end, such as Roth conversion ladders and tax gain harvesting.  These are completely legal ways to reduce your tax burden by just understanding the tax code.  So even though you will likely owe some taxes on distributions from your pre-tax accounts in the future, it may not be as bad as you think if you play your cards right.

What We Do

Perhaps the best way to demonstrate the principles in maximizing these accounts is to give you an example.  I’ll use what we do to hopefully show you how this concept can be put into action.  Of course there are countless variations on this based on what accounts people have access to, their income, and their financial goals.  This is just one example.  Again, a good financial advisor could potentially be very helpful in determining what is best for you.  

403(b)

In line with the FI movement, we prioritize our pre-tax accounts.  Through my employer, I have access to a 403(b) employer sponsored retirement plan.  We start by contributing the necessary amount to get the full employer match.  Then, I continue to have deductions taken out of my paycheck throughout the year until we have maximized our contributions to this account.  In 2020 this is $19,500.

Non-Governmental 457(b)

In addition to the 403(b), I also have access to a non-governmental 457(b) account.  It’s not quite as good as a 401(k) or 403(b) account.  For example, there is no employer match and when I leave the company or retire I have to withdraw the money as a lump sum (bad tax move), have it distributed over five years (better, but not great), or over ten years (the best tax move and what I plan to do).  But even with some of the drawbacks, it is another pre-tax account that offers significant tax savings now.  Through further paycheck deductions we maximize contributions to this account as well, which is also $19,500 in 2020.

Health Savings Account (HSA)

Last year we also made the switch to a high deductible health plan which allows us to contribute to an HSA.  Again, this is the only triple tax advantaged account, so we made the change to take advantage of this.  We also contribute to this account through paycheck deductions throughout the year.  We contribute the maximum amount, which is $7,000 for families in 2020. 

These pre-tax accounts are all through my employer, so all of our contributions are through paycheck deductions.  This means we don’t prioritize one account over another, but rather fill these buckets concurrently over the course of the year.

To show you how powerful these pre-tax buckets can be, let’s calculate how much we’ll save in federal income tax in 2020.  By contributing the maximum to these three accounts, the total amount of pre-tax contributions will be $46,000. This means that these contributions allow us to decrease our taxable income by $46,000.  Since we are currently in the 37% tax bracket, this will save us $17,020 in income tax in 2020 (0.37 x 46,000).  Not too bad.  

Backdoor Roth IRA

Next, typical FI doctrine would say to contribute to another pre-tax account, the traditional IRA, to get the guaranteed tax benefit now.  However, if you are covered by a retirement plan at work and married filing jointly, and if your income is greater than $124,000, you cannot deduct traditional IRA contributions from your taxable income (IRS.gov).  So, no significant tax benefit there.  

OK, how about the Roth IRA?  If we can’t contribute to any more pre-tax accounts, then the next best option would be a post-tax account, like a Roth IRA.  In our situation, however, our income is too high to directly contribute to a Roth IRA. This is where the back door Roth IRA comes into play.  

My wife and I each make a non-deductible contribution to our traditional IRA accounts ($6,000 each in 2020).  Then, we each convert this to our Roth IRA accounts.  This allows the money to grow tax free, and then be withdrawn tax free in the future.  If you want to learn more about the nuts and bolts of the backdoor Roth IRA, I recommend the White Coat Investor links here and here.

529 Plans

We also contribute to 529 plans for each of our kids.  This account has the lowest priority for us in the tax advantaged space because I believe it is more important to secure your own future first before paying for your kids college.  I talked about this in my post Please Secure Your Own Oxygen Mask First.  They can get a loan for school if needed, but you can’t get a loan for retirement.   

We only contribute the amount to get the state income tax deduction, which is $3,340 per beneficiary for 2020 in Wisconsin.  Remember, there is no federal tax deduction for 529 plans.  I don’t overload these accounts beyond the amount to get the state income tax deduction because I don’t want an excessive amount of money invested under the restriction of educational spending.  This money can then grow tax free, and won’t be taxed upon withdrawal so long as it is for qualified educational expenses.   

The Roth IRA’s and 529 plans are not through my employer, so they aren’t funded through paycheck deductions.  So, how do we fund these accounts?  We use our tax refund each year.  In a previous post I talked about why I like getting a larger tax refund.  While many would argue it’s not the best use for your money and it’s like giving the government an interest free loan, from a behavioral standpoint overpaying on taxes in a way forces you to have another pseudo savings account.  When you get this larger lump sum of money in your tax return, most people tend to be more responsible with it (more likely to save or invest it).  We use it to contribute to our Roth IRA’s, 529 plans, and other investments.  For us, I think we are more likely to use the money investing for our future in this way, as opposed to getting a slightly larger paycheck every 2 weeks.

 These five accounts max out our available tax advantaged space in our situation.  Remember, your situation and available accounts could be very different.  

What Should I Invest In?

Now you may be asking, what should I invest in?  While it’s not the purpose of this post, nor my blog, to give specific investment advice, I do believe there are some basic principles you should abide by.  

First, I would recommending choosing an asset allocation that fits your risk tolerance, time horizon, and is in line with your financial plan.  Generally, the higher your risk tolerance and longer your time horizon, the larger the percentage of your portfolio should be allocated towards stocks.  Conversely, the lower your risk tolerance and shorter your time horizon, the larger the percentage you should have allocated towards bonds.  I’ll write more extensively on asset allocation in the future.  

Second, you should choose funds that are well diversified and have low fees.  I don’t advocate picking individual stocks.  I recommend choosing low cost index funds.  For stocks, I recommend a total stock market index fund or an S&P 500 index fund.  For bonds, a broad based total bond market fund.  These types of funds may not be available in all employer sponsored retirement plans, so pick something as close to them as possible.  They should be available in most IRA accounts.   

Third, If you are interested in less tax efficient assets, like real estate investment trusts (REITs), then your tax protected space is a good place to invest in them since your investments can grow tax free.

Conclusion

Congratulations on getting to this point in your journey.  It takes a considerable amount of financial discipline to get this far.  Now it’s time to save on taxes and maximize the tax advantaged accounts you have available to you.  These accounts can widely vary based on if you are an employee, self-employed, or work for the government, but the principles are the same: do all you can to minimize your tax burden and save for your financial future.  After you fill these tax advantaged buckets, we’ll talk about what to do next in steps 10 and 11.

Here are some take home points to consider:

• Taxes are likely your biggest expense.  One of the core principles of FI is to reduce expenses.  One way to significantly reduce your largest expense is by maximizing your tax advantaged accounts.  

• Consider maximizing your pre-tax buckets first to get the guaranteed tax benefit today.  After filling your pre-tax buckets, move onto your post-tax buckets if possible.  

• Choose low cost, diversified investments that match your risk tolerance, time horizon, and future financial goals.  

Thanks for reading.  I hope you are doing well in your progress towards reaching FI.  If you have any questions or comments that might help other readers, please list them below.  In the meantime, keeping working towards Freedom Through FI!

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