Disclaimer: I am not a professional financial adviser, and this series in not meant to provide individualized financial advice. I am just one guy who did well enough to become financially independent at age 35. This series simply shares the lessons I learned for your entertainment.
By The Pointer
It’s great that Travis now knows how he can avoid income taxes in the future, but he doesn’t have any stock investments yet. Living off of capital gains tax-free is a dream that’s far down the road. We need to help him reduce his taxes today while he’s earning ordinary income and trying to make this way toward financial independence. The best way he can do that is by using tax advantaged savings vehicles. Let’s go into what these things are, and how Travis can use them to his benefit.
Health Savings Account
Many employees opt to put a percentage of their paycheck into a 401k account. These accounts are sometimes called traditional 401ks to contrast them with Roth 401ks, which we’ll talk about next. Let’s say Travis elects to have 10% of his earnings put into a 401k account. That means $9,200 per year ($92,000 gross income x 10%) will be taken out of his paychecks, and deposited in his 401k account. He can take the money in his 401k account, and invest it in whatever his employer’s 401k plan allows. Usually, this means buying mutual funds composed of stocks and bonds.
No Income Tax on Contributions
The best part is that he doesn’t have to pay income tax on the $9,200 he contributed, which could save him $2,024 in income taxes this year. This money that he would have saved and invested anyway, but now, it reduces his tax bill.
There are a few things to note about the calculations above:
- Travis avoided paying 22% tax on the $9,200 he put in his 401k (22% x $9,200 = $2,024). That’s because of the progressive tax brackets. He avoids paying taxes on money in his highest tax bracket.
- His FICA taxes didn’t change. 401k contributions don’t affect the FICA tax calculation.
Potential Employer Match (Free Money!)
The other common benefit of 401k programs is that employers often match your contribution with a matching contribution of their own (…and that matching contribution isn’t taxed either). Far too many people don’t take advantage of this. That match is free money! Travis’s company gives a 100% match of his contributions up to 4% of his gross salary. Since Travis contributed greater than 4% of his income, his employer will put $3,680 (4% x $92,000) into his 401k account. Some people think 401ks are too complicated or they spend that money on other things, but that means they are missing on this free money. If you do nothing else after reading this series, at least make sure you’re contributing up to the maximum that your employer will match.
Some 401k Downsides
Naturally, the 401k comes with a few drawbacks that you should be aware of. First of all, you can’t directly withdraw money from your 401k account until age 59.5 or else you’ll have to pay a 10% penalty. There are ways around this, which we’ll discuss later in the series, but it’s certainly a limitation.
Second, not all employers offer 401k programs. Usually, they’re offered by mid-size to large-size companies.
Third, some employers offer it, but have bad investment options. In other words, you can contribute money, but when you try to invest that 401k money, you’re stuck with mutual funds that don’t offer the investment options you want or that have high expense ratios. We’ll talk more about how to spot a bad option later in this series.
Fourth, you’re required to start withdrawing money from your 401k at age 70.5. Basically, Uncle Sam says, “I want some taxes!” Many people would have started withdrawing money, anyway, so this is no big deal. Others have investments that do so well that they don’t need to withdraw much money from their 401k. They may want to leave it there, and let their heirs inherit the money they won’t use. With required minimum distributions (RMDs), you may be forced to withdraw more than you need and pay tax on that money.
Finally, there’s a limit on how much you can contribute to a 401k. As an employee, you can contribute up to $19,000 of your own salary (in 2019). The employer match doesn’t count against this limit.
All in all, the 401k is a powerful tool when you’re saving for financial freedom!
The Roth 401k is identical the 401k with just a few twists.
Pay Income Tax Now, Avoid It Later
The biggest difference is that while the money you contribute will still be subject to federal income tax, you won’t have to pay any tax on the withdrawals. While this is a wonderful benefit, let’s see why it might not be a great option for Travis.
We already saw that Travis can save $2,024 in taxes in 2019 if he put money in his traditional 401k. Conversely, he wouldn’t save any of that money if he puts it in a Roth 401k. It’s clear that he’ll do better today if he can reduce his taxes.
What about the future? The point of the Roth 401k is supposed to be that you’re making a sacrifice now in order to be free of taxes later. We’d need to compare what Travis is saving today versus what he’s saving in the future. To do this, let’s take a few things into consideration:
- Future tax savings of the Roth 401k versus the current tax savings of the traditional 401k
- The ability to invest the $2,024 that Travis avoided paying taxes on in 2019
For the simulation below, I’m look at everything in today’s dollars. Inflation won’t matter, in theory, because even though $9,200 in the future in the future won’t be as valuable as it is today, the tax brackets and standard deduction will also grow at the rate of inflation so it’s a wash.
Now, let’s look at the future tax savings of a Roth account. We can look at that two ways. First, what if the $9,200 Travis put into his traditional 401k or Roth 401k was the first $9,200 he withdraws when he’s over age 59.5? Let’s say he’s 60 at the time. Well, he wouldn’t pay any tax because it’s less than the standard deduction ($12,200). He wouldn’t have any taxable income anyway so the traditional 401k is the better choice because he’s saving $2,204 today and nothing in the future.
Wait, what if that $9,200 he wants to withdraw isn’t his first $9,200, but his last $9,200? After all, Travis wants to retire with his current standard of living so that’s $54,714 per year. Let’s assume he’s getting the rest of his money from other sources like rental income from properties that he owns. Then, he will have to pay tax on that $9,200. It’ll come to $669 (see calculations below). He’s still doing better with the traditional 401k. I’d rather save $2,204 now than $669 in the future.
But wait, that’s still not the end of it. We have to look at the value of his investments. The main investment is a wash. $9,200 invested in a traditional will be worth the same as $9,200 invested in a Roth 401k assuming the same underlying investments. However, with the traditional 401k, Travis saved $2,024 in taxes that he can invest. Because of that, his portfolio will be worth about $15,407 more by age 60 if he uses a traditional 401k.
While he’ll have $70,033 in both his traditional 401k and Roth 401k, the money Travis put into his Roth 401k has grown tax free, and will be withdrawn tax free. What’s that worth? Assuming he’s withdrawing $54,714 per year for his annual expenses, he’d pay $5,212 more if he’s taking that money from a traditional 401k. That sucks, but he’ll come out ahead with the traditional 401k.
All in all, Travis is doing by choosing a traditional 401k and investing the tax savings. The increased value of his portfolio will be much greater than any taxes he’s avoiding by choosing a Roth 401k. This is the case for most people because most of us are paying higher taxes today than we expect to in retirement. The golden rule for choosing between a traditional and Roth 401k is that you should invest in the traditional IRA if your marginal tax rate today is higher than your expected tax rate on your withdrawals in retirement. If the reverse is true, invest in a Roth 401k.
You can withdraw contributions early
Let’s keep in mind that there are other wild card factors that aren’t considered in these scenarios. For example, what if Travis had an emergency, and needed to withdraw $9,200 from his Roth 401k. With a Roth 401k that’s possible (if he’s had that money in his Roth 401k for 5 or more years). You can withdraw contributions (though not investment gains) from a Roth 401k before age 59.5, and it’s still tax free. That’s an advantage for the Roth 401k, but I’d argue it’s not a meaningful advantage for most people pursuing FI. After all, Travis wouldn’t only be investing in retirement accounts. He’s also building an emergency fund, and investing his money outside of retirement account. There are other (and better) ways to pay for an emergency expense than going into his Roth 401k.
Will it really be tax-free when withdrawn?
The other wild card factor is that we’re assuming Travis’s future Roth 401k withdrawals will be tax free. Sure, that’s what the law says today, but that’s not a guarantee. When Social Security began, the benefits weren’t taxed. In 1984, that changed with an act of Congress. I could easily see a situation where the government is running into a major deficit/debt issue, and needs to raise revenue so they put a tax on Roth withdrawals or only allow it be tax free for withdrawals under $25,000 per year. I’m confident no one would bat an eye because very few people would be affected, and most of the people affected probably wouldn’t fully understand how it impacts them.
The tax savings from a traditional 401k contribution today are certain. The tax savings from a Roth 401k withdrawal in the future are theoretical.
Traditional and Roth Individual Retirement Accounts (IRA)
Individual Retirement Accounts or IRAs are just like 401ks in most ways: they’re tax-advantaged retirement accounts (traditional IRA contributions are tax free, Roth IRA withdrawals are tax free). There are a few differences, though.
First of all, the IRA is managed by you, not your employer. With a 401k, your employer decides the company that manages the 401k (eg. Fidelity, Vanguard, etc.) and what investment options are available. With the IRA, you can choose what company you want to work with, and you choose your own investments.
Different Limits and Rules
Second, there are more limitations on IRA contributions. While an employee under 50 can contribute up to $19,000 of their own paycheck to a 401k, they can only contribute $6,000 to an IRA.
There are also some income restrictions. Anyone can contribute to a traditional IRA, but you can’t deduct the contributions unless your income is below is a certain level (see table), and it depends on whether you have access to a separate retirement plan like a 401k at work.
With the Roth IRA, there are also income limits where people can’t contribute when their income is above the limit:
Based on these tables, Travis earns too much to deduct any contributions he makes to a traditional IRA (since he has access a 401k at work). However, he could contribute up to $6,000 to a Roth IRA in 2019.
The third difference between IRAs and 401ks (or at least traditional IRAs and 401k) is that you’ll have to have a slightly more complex tax filing in April. With a traditional 401k, your employer takes care of all the paperwork. The money is directly taken from your paycheck, and the contributions are noted in the W-2 that they send you at the end of the year. You upload that W-2 form into our tax service’s system, and all is good with the world.
With a traditional IRA, you’ll have to contribute from your post-tax earnings, and then tell the government (through your tax filing) that they owe you a refund because that money shouldn’t have been taxed. It’s really not complicated, and pretty much every online tax service allows you to do this very easily. It’s just not as easy as a 401k contribution.
No RMDs for Roth IRAs
Roth IRAs have a unique benefit that Roth 401ks don’t have: no required minimum distributions. Considering you can just convert your Roth 401k into a Roth IRA once you leave your company, you might as well to get this benefit. It’s not a meaningful benefit for everyone, but why give it up if you don’t have to.
No need to choose
IRAs have great benefits. Possibly the best is that you don’t have to choose between an IRA and a 401k. You can contribute to both to reduce your taxable income (or protect it from future taxes with a Roth).
Health Savings Account (HSA)
The health savings account or HSA gets the least amount of attention, but it could potentially be the best retirement vehicle.
What it is
Hopefully, we’re all familiar with health insurance. If you know health insurance, you probably know what deductibles are. They’re the amount you have to pay toward your own healthcare costs before the insurer starts paying. If you have a $2,000 deductible, then your insurance doesn’t kick in until you’ve spent at least $2,000 on your own healthcare.
If you have what’s considered a high deductible healthcare plan (HDHP), then you’re eligible to open an HSA. With the HSA, you can make tax-free contributions to a savings or investment account. Then, you can withdraw that money at any time (tax free) to pay for eligible healthcare expenses.
A retirement account in disguise
Here’s the good part. That HSA money can be invested in stocks and bonds so it grows over time. Also, when you turn 65, you can withdraw that money for any reason, not just healthcare expenses. Those withdrawals are taxable (just like withdrawals from a traditional IRA or 401k), but if you’re Travis (and most people are like Travis) then you expect your tax rate at 65 to be much lower than it is today so you’ll save on taxes in the long run by investing in an HSA.
Reduces both income and FICA taxes
If the HSA basically being a traditional IRA in disguise wasn’t good enough, there’s another benefit that’s even better: the money you contribute to an HSA isn’t subject to income tax or FICA (Social Security and Medicare) taxes.
If you remember, Travis is stuck paying 7.65% of his income in FICA taxes no matter how much he contributes to his 401k or IRA. This isn’t the case with HSAs. Let’s look at the math, and see the impact of contributing $3,500 to a HSA versus contributing the same money to a 401k versus doing nothing.
It’s clear that Travis could minimize his taxes by contributing to his HSA before he starts contributing to his 401k. Naturally, this assumes he won’t touch this money until he’s 65 (or that he’ll use it for medical expenses), but given the relatively low contribution limits for HSAs ($3,500 for an individual and $7,000 for families in 2019), it won’t have a massive impact either way.
Yes, you can do this + IRA + 401k
You can contribute to an HSA on top of also contributing a 401k and an IRA. For a single filer under 50 like Travis, that’s the potential for at least $3,500 + $19,000 + $6,000 = $28,500 in tax advantaged savings.
Don’t choose it if it’s not the best healthcare plan for you
Remember, healthcare is expensive. You’re only eligible to set up and contribute to an HSA if you have a high deductible health care plan. That means your plan deductible is at least $1,350 for individuals or $2,700 for families.
If you know you’ll have massive healthcare bills, and your employer offers a $100/month traditional insurance plan with no deductible or co-payments or a plan with a $6,000 deductible and an HSA, don’t choose the HSA unless the tax benefits are worth more than $4,800 ($6,000 - $100 x 12 months). However, the reality for most people is that they’re offered no choice or a few crappy choices, and one of those choices happens to be an HSA so you might as well get the tax benefits.
Comparing the Pros and Cons of Each
The Order of Priorities for Tax Reduction and FI Savings
Was all of that too much? I know that Travis’s head is spinning with all of the things he “should” be doing to reduce taxes and save for the future. Some people are in a fortunate position where they can save the maximum in all of these special retirement accounts, but others have to prioritize what to do with limited funds. Let’s talk about the order to go in.
- Contribute to a 401k up to the matching point
- Pay off high interest rate debt
- Build a 3-month liquid emergency fund (for now)
- Contribute to your HSA
- Contribute to your IRA or 401k
- Make normal post-tax investments
#1 Contribute to a 401k up to the matching point
If your employer is matching 100% of your contribution up to 4% like Travis’s employer, contribute AT LEAST 4% of your income to a traditional or Roth 401k. That’s a guaranteed, immediate 100% return on every dollar you contribute…and it’s tax free! This is free money that no one should pass up. Remember, employer matches/contributions don’t count against your $19,000 employee contribution limit. Since Travis makes $92,000/year, he’s going to contribute at least 4% x $92,000 = $3,680 to his traditional 401k. We already reviewed why a traditional 401k makes more sense for him than a Roth 401k.
Even if his employer only matched 50% of his contribution, it shouldn’t be passed up. A guaranteed, immediate 50% return is still a much, much higher upside than any other investment he could make (or any downside he could avoid like paying off debt with a 20% interest rate).
#2 Pay off high interest rate debt
While it’s fun to start making investments and saving money on taxes, all of that pales in comparison to the money wasted on credit card interest every year. You have to pay down high interest debt, which I’d say is debt with an interest rate greater than 6%, before you move lower on this list. That’s for a few reasons:
- Greater savings than the lost earnings: If Travis wasn’t paying down debt, where would that money go? If he’s following the plan he set out, it would be invested in the stock market where he’d get a 9% - 10% return on average (remember the 7% we’ve been using is after adjusting for inflation, and I’m trying to make an apples to apples comparison here). Credit card debt can easily have a 20% interest rate or more. Mathematically speaking, you’re better off using $1,000 to pay down a 20% loan ($200/year saved) than investing it in stocks (potential $100/year earned).
- Risk free return: So why did I suggest paying down debt with a 6%+ interest rate, when you can earn 10%ish in the stock market by investing. Shouldn’t my recommendation be to pay down 10%+ debt? Not necessarily. I’m adjusting my recommendation for risk. Everyone’s tolerance is different, but that 10%ish people earn in the stock is a historical average. You don’t know if the market will go up 20% this year or drop 30%. However, you do know with certainty how much you’ll save by paying down your debt. That certainty is important. I’d rather know for sure that I’m saving at least 6%/year than hope that I earn 10%/year.
Aside from these dry reasons, some people also like the idea of not owing money to others. That’s a personal factor that I can’t quantify, but it’s certainly another factor in favor of paying down high interest debt.
The next common question is, “Which of my debts should I start paying off first?” There are two common approaches:
- The Debt Avalanche Approach: This approach says you should start paying off your debt with the highest interest rate first. If you owe $50,000 in student debt at 10%, $10,000 in credit card debt at 20% and $1,000 on a car loan at 8%, the Debt Avalanche approach would say you should start by paying off the credit card debt (the highest interest rate first), then the student loan, then the car loan. This is the mathematically superior approach, but it’s harder for people to stick to in some cases.
- The Debt Snowball Approach: This approach says you should start paying off your smallest debt first. In other words, it would the $1,000 car loan in the example above. Studies shows that the psychological benefit of seeing debt completely disappear makes people more likely to continue paying down debt. Which approach is better is up to you, but you’re a winner if you pay down high-interest debt regardless of how you do it!
For Travis, we’re going to assume he’s free of high-interest debt. This isn’t true for most people (cough…student loans…cough), but this series wouldn’t be very helpful if we just stopped here. However, the importance of paying off high-interest is not to be understated; neither is the time it takes for many people to pull this off. I spent years paying down my student loans before any kind of meaningful investing was even an option.
#3 Build a 3-Month Liquid Emergency Fund (For Now)
We all need to be able to respond to emergencies. What if Travis loses his job? What if he has a car accident that causes damage his insurance doesn’t cover? He should have access to money that can be used to pay these unexpected costs. The biggest one to watch out for is his losing his job. That’s why the fund should have enough money for him to live on for 3 months. He believes that’s enough time for him to find a new job should he lose the one he’s in. However, everyone has a different definition of what’s safe.
Travis already has $7,679 in a savings account. If he adds another $6,000, he’ll have 3 months of expenses covered. Remember, that money doesn’t have to go to a savings account. He just has to have access to it. Luckily, that’s also the maximum he can contribute a Roth IRA. That’s what he’s going to do because he can always withdraw his contribution (just not any earnings on top of that contribution) tax free. Why not kill two birds with one stone?
Why did I say he should create an emergency fund “for now” in the headline above? Because his FI savings are basically one gigantic emergency fund. Eventually his Roth IRA contributions and post-tax investments will be in the tens of thousands of dollars. If he had to, he could always sell them to pay emergency expenses. If you disagree with this assertion, I’ll see you in the Extra Credit section of this series!
Why does the temporary emergency fund come after paying down high-interest debt in this list? Well, because that debt is an emergency! All of those interest charges bury people in debt where they may never escape if they don’t take action quickly. Also, should an emergency come up, and you don’t have an emergency fund, but you have been paying down debt, you’re in a better position to take on some temporary debt if needed. Not to mention, as you pay down your debt, the interest costs come down so your costs in the event of an emergency will be lower.
#4 Contribute to your HSA
We already covered this one, but money that you contribute to an HSA avoids both income tax and FICA taxes. Plus, the money can be invested so it grows (just like a 401k or IRA), and it can be withdrawn for any expense (just like a 401k or IRA) but at age 65 instead of 59.5. You can always use it before age 65 for qualified medical expenses.
Travis is going to do two things make this possible:
- He’ll pay $15/month ($180/year) to join his employer’s high-deductible health plan so he can make HSA contributions. After all, if he maxes out his HSA contribution, he’ll save $1,038 in taxes (that’s $268 more than if he put $3,500 in a traditional 401k). Plus, he’ll have health insurance, which I hear is good to have in case of a medical emergency!
- He’ll contribute the maximum ($3,500) to his HSA, and put that money into stock investments (we’ll go into what he’ll invest in in the next installment of this series).
#5 Contribute to your IRA or 401k
So which is it IRA or 401k? Well, it depends. In Travis’s case, he should contribute to his 401k next for two reasons:
- He already maxed out his IRA contribution by putting $6,000 for his emergency fund into a Roth IRA, but let’s ignore that for now.
- He makes too much money to be able to deduct traditional IRA contributions from his income. We already established that Travis’s current marginal tax rate than he expect his tax rate to be after financial independence. He should be trying to reduce his taxable income today if he can. He can still do that by contributing to a traditional 401k.
What about people who aren’t Travis? When there’s an option to contribute to either one, I’d recommend contributing to the account that gives you better investment options. Some employer’s 401ks offer special funds with really low expense ratios that are only offered to institutions. Other people have crappy 401k investment options, and would do better picking their own investments through an IRA. Again, we’ll cover this more in the next installment on investing.
#6 Make normal post-tax investments
Wow, so you have no high-interest debt, access to at least 3 months of expenses, contributed the max to your HSA, contributed the max to your IRA, contributed the max to your 401k and you still have money leftover? Good for you! You now have the wonderful dilemma of deciding what to do with that money.
My recommendation would be invest that money in the stock market (outside of any special tax-advantaged account). Remember, you’ll be earning a 7% real return on average (or 9% - 10% in nominal terms if you factor in inflation).
Some people want to use any “extra” money to pay down other debt such as a home mortgage. Mathematically, I’d say that they’re wrong in most cases, but the psychological benefits of having a paid off home is very important to some people.
Exceptions to the rules
As with all systems, this one isn’t fool proof. It’s probably good advice for most people most of the time, but there are always a few exceptions.
One exception is for people with too much money in tax advantaged accounts that they can’t access early. In the Extra Credit section of this series, we’ll talk about how you can actually access a lot of traditional 401k/IRA money before age 59.5, but even those tricks have limits. Someone very close to financial independence, who isn’t anywhere near age 59.5 and has almost all of their money their traditional 401k, traditional IRA and HSA may want to put more money in a Roth IRA/401k or normal post-tax investments.
There’s also the wildcard that is the human factor. Maybe you lose sleep at night worrying that the bank will take away your home, and you’d feel much more secure paying down your mortgage. Maybe you kids are in college, and you’re willing to sacrifice your own retirement to make sure they come out of college debt free. These are all personal decisions that can’t easily be factored into any formula.
So what do Travis’s finances look like now?
Well, first let’s summarize what he’s actually able to do given his financial situation:
- He contributed $3,680 (4% of his gross income) to his traditional 401k so he could get another $3,680 from his employer (the 100% match)
- He contributed $6,000 to a Roth IRA to make sure he has access to a 3-month emergency fund
- He contributed $3,500 (the maximum) to his health savings account
- He contributed an additional $7,240 (for a total of $10,000 in contributions) to his traditional 401k
Here are all of his numbers:
Yep, he just saved an extra $6,597 due to the tax savings and employer 401k match, and he reduced his time to FI by 7 years! The best part is that he didn’t have to earn more or cut any expenses. He was just a little more knowledgeable and intentional about how he saved his money so he could minimize his taxes, and maximize his investments. While this wasn’t simple, it’s extremely powerful!
The Living Freely Series Table of Contents
Step 3, Part 1: Cutting Expenses
Step 3, Part 2: Increasing Income
Step 3, Part 3: (Legally) Avoiding Taxes - Part 1
Step 3, Part 4: (Legally) Avoiding Taxes - Part 2
Step 4: How To Invest Your Savings
Step 5: Achieving Financial Independence