Updated and expanded for 2015. In 2015, the name of the tax changes game is the Affordable Care Act, or Obamacare. This is the second year citizens will be penalized for not having health insurance. Along with this comes a new tax credit — the Premium Tax Credit — for purchasing qualifying health insurance through the Marketplace. How does this effect your investments? It’s important to consider tax effecient investing whenever possible. Here’s what I mean.
What is Tax Efficient Investing?
When it comes to investing for the long haul, it’s always important to consider taxes, as the capital gains minus taxes can be significant. The followers of Jack Bogle (otherwise known as Bogleheads) are also a big fan investing tax efficiently. Though their list is somewhat incomplete, I also believe this is an effective way to invest.
When investing on an annual basis, it’s best to fill up your accounts in the following order:
- Your Employer’s 401(k)/403(b) up to matching amount
- Invest the maximum in a Traditional IRA (assuming you qualify)
- Backfill your 401(k)/403(b) to the maximum amount
- Roth IRA (if you don’t qualify for a Traditional IRA move to step 2)
- Invest in a 529 account
- Health Savings Accounts
- US I Savings Bonds
- MLP and Muni Bonds
- Taxable investments
If you have a spouse, you would also do the same order to their accounts (if all options are available) as you would do for yourself. Based upon your needs and goals, this order may slightly vary. You may also choose to skip a step because of various reasons or poor investment options.
For your specific investment needs, you may want to consult your accountant and/or a financial advisor. The basic gist from this list is to invest first in items that give you the greatest tax reduction or tax delay. Let’s go over the list one by one.
If you’d like to hear even more about this subject, check out my podcast interview with Listen Money Matters.
1. 401(k)/403(b) up to Employer’s Matching Amount
With a 401k you usually get two forms of “free” money. Your AGI (Adjusted Gross Income) is lowered which effectively lowers your income at least for federal taxes. The second factor is most companies match 3-4% of what you invest. This is the reason to invest in these first and contribute at least up to what the employer matches. Granted some employer retirement plans suck. Some plans do not have cheap and indexed based mutual funds (i.e. Vanguard), or have only a limited selection of funds. At least on the bright side you are getting a 3-4% automatic return if your company matches.
If your company does not offer matching, you might want to skip this step and revisit it in step 3.
2. Invest the Maximum in a Traditional IRA
For 2015, the maximum contributions for a Traditional IRA remains the same at $5,500 per year ($6,500 if over 50). Invest the maximum amount. Open up an account with a firm that offers low transaction fees like TradeKing.
Traditional IRAs are just like 401(k)/403(b) because they are tax deferred. The greatest benefit is much more freedom in investment choices. Unlike your employer’s plan, you are only limited in the firm investment options you open an IRA account with. With IRAs it’s possible to buy physical gold, to real estate (not REITs!), to alternative investments like Lending Club, and, of course, more traditional investments.
The only catch is if you make too much income and your company offers a retirement plan, you might be disqualified from making contributions.
- For single filers who are covered by a company retirement plan, the deduction is phased out between $61,000 and $71,000 of adjusted gross income.
- For married filers who are covered by a company retirement plan, the deduction is phased out between $98,000 and $118,000 of adjusted gross income.
- For married filers where you are covered by a company plan but your spouse is not, in 2015 the deduction for your spouse is phased out between $183,000 and $193,000 of adjusted gross income.
3. Backfill Your 401(k)/403(b) to the Maximum Amount
After filling up your Roth IRA account for the year, you are usually best to go back and back fill your employer’s retirement account to the maximum. For 2015, this means up to $18,000. For employees aged 50 or older, you can add an additional $6,000 to that amount.
The decision to perform this step depends upon how bad the the available funds within your retirement account are. I once worked for a company who only offered managed funds with very high annual fees (2%+) and only had a choice of six different funds which all performed poorly. In my case, I only invested up to the matching.
4. Roth IRA
If you already invested the maximum in a traditional IRA in step 2, you cannot add to a Roth IRA as well. Roth IRAs apply more to individuals who do not qualify for a traditional IRA.
Unfortunately, with Roth IRAs you must invest with after tax dollars, though they have quite a few advantages over a 401(k)/403(b) or traditional IRA. The Roth IRA phase out ranges for 2015 are:
- Single filers: Up to $116,000 (to qualify for a full contribution); $116,000–$131,000 (to be eligible for a partial contribution)
- Joint filers: Up to $183,000 (to qualify for a full contribution); $183,000–$193,000 (to be eligible for a partial contribution)
- Married filing separately (if the couple lived together for any part of the year): $0 (to qualify for a full contribution); $0–$10,000 (to be eligible for a partial contribution)
A traditional 401(k)/403(b) or IRA reduces your AGI, but you must pay taxes when you withdraw. A Roth IRA, on the other hand, is invested with after tax money, but when you retire, withdrawals are currently tax-free. In addition, there are not mandatory withdrawals once you reach a certain age, and can be inherited.
Normally once you reach the IRS income limits listed above, you cannot contribute to a Roth IRA. Though there is a legal backdoor method to contribute to an Roth IRA regardless of your income.
Roth IRAs are commonly used by higher income individuals. Typically what happens is someone just graduating from college will qualify for the traditional IRA. This makes sense to first invest with. As you move up the corporate ladder and your income increases, it possible you don’t qualify for a traditional IRA. If this is the case, a Roth IRA is your next best option. To better effectively manage your retirement and withdrawal plans, you should have both types of IRAs.
With either IRA, it’s wise to use them to create a proper asset allocation for retirement. Meaning if your 401(k) offers a poor choice in mutual funds or doesn’t offer specific asset class (i.e. international stocks), an IRA account should be used to fill in that gap.
5. Invest in a 529 account
If you have children or have future higher education needs yourself, it’s best to invest money into a 529 plan. If you don’t have any needs in this area, you can skip this step.
Money invested is after tax but is tax free when withdrawn for qualified higher education. In some states, like New York for example, you get a state tax deduction when investing. Not all 529 plans are created equal, so it’s important you do your research and open one that’s best suited for you and your children.
Unfortunately, many parents save for their children first, instead of taking care of their retirement plan first. Retirement plans should always be funded first since you cannot take a loan out for retirement. In addition, there are situations in which IRA accounts can be used for higher education without penalty.
6. Health Savings Accounts
A Health Savings Account (or HSA) is an excellent way to get a tax deduction for medical expenses and take advantage of tax efficient investing. A HSA is a sort of savings account that’s linked to a high-deductible health plan, and allows you and your family to use the funds for qualified medical expenses.
Going this route usually saves you up to 20-30% off your medical bills because you’re paying up-front. The funds contributed into the account are from tax-deductible contributions, and can help lower your tax bill at the end of the year. Any interest earned on these funds is tax-deferred, and any withdrawals from the account are tax-free when spent on approved medical expenses.
Unlike a traditional Flexible Spending Account (FSA) the funds in a Health Savings Account are not use or lose it, and your money will continue to accrue and grow interest until you withdraw the funds for medical purposes.
Additionally, the funds never expire and are completely within your control. This is a great option for self-employed business owners who can’t afford to pay high health insurance premiums.
Once your HSA reaches a certain dollar amount (usually $2,000 or more) you can open an HSA Investment Account, and choose from a variety of mutual funds. This type of HSA can help supplement your overall retirement goals, while protecting you with the health insurance coverage you need.
7. US I Savings Bonds
As mentioned previously, I am a big fan of US Savings I Bonds. I think they are a great way to invest some money that’s indexed to inflation, and yet be tax deferred while holding the bond.
They can serve multi-purposes in your portfolio (i.e. emergency funds), and can be used for higher education needs tax-free. At minimum, invest a few thousand annually with maximum $10,000 per social security number (plus an additional $5,000 in IRS refunds per Social Security Number). They can be a used at part of your retirement bond portfolio.
Deciding to invest in I Bonds also depends upon the fixed rate component and other investment opportunities. The current fixed rate seems to be always sub 1%, so it’s not as an attractive deal compared to previous years. It will at least keep up with the CPI rate.
8. MLP and Muni Bonds
This is an optional investment as it depends upon your income level, and how complex you want your tax situation. Though, MLP are a great way to get a steady return, and yet most of it be tax deferred. The disadvantage to a MLP is they are much more complex to deal with when filing your taxes. It is usually recommend to hire an accountant to properly file your taxes when owning a MLP.
Investing in muni bonds depends upon your income level and the state you live in. High income individuals are usually the best to purchase these bonds. The higher your income, the higher your the effective returns are with Munis, because the returns are not taxed.
If you have enough money ($200k+) you can directly purchase these bonds, if not, you are best to stick with an index-based mutual fund or ETF to get proper diversification.
9. Taxable Investments
After every other item has been filled, only then is it time to invest in taxable accounts. Of course, if you have other goals than retirement and higher education (i.e. buying a house or rental property), you may want to push this item higher up the list. Obviously you have much more flexibility with taxable investments.
When investing in your taxable accounts it’s typically best to make sure they are still tax efficient. This means investing in mostly stocks, ETFs, index based mutual funds, and tax efficient mutual funds. If you are using it as part of your retirement planning, it should be considered as part of your asset allocation. This means, for example, putting stocks with no dividends into your taxable accounts. In addition, it’s best to find a broker who has low commissions, and offers commission free ETFs to minimize your expenses.
Keep in mind like any part of investing, one should not invest solely for tax avoidance. Do not miss investment opportunities just because it’s tax inefficient, though it should always be considered with your planning.
As your various investment accounts grow in dollars, you’ll be able to put new investments in the most tax efficient account.