Ever since Obamacare came into effect, some citizens have felt a bit of a tighter squeeze at tax time. This has included penalties for not having health insurance, as well as a 3.8% surtax on some high earners’ investment income. And despite the efforts of some GOP senators to repeal the Affordable Care Act, it looks like it’s not going away anytime soon. So how can you keep more of your assets in your wallet?
There are three ways to pay less in taxes: avoid, delay, and evade. And since that last one will eventually land you in prison, it’s smarter to look at the other two solutions. And you can do that through tax-efficient investing.
What Is Tax-Efficient Investing?
Tax-efficient investing involves considering Uncle Sam in every investment choice you make. This is especially important when it comes to investing for the long haul, since taxes on capital gains can be significant.
The followers of Jack Bogle (otherwise known as Bogleheads) have created a nine-step plan to help you invest in a tax-efficient manner. Though it’s somewhat incomplete, I agree that this list provides individuals with 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 the matching amount
- A traditional IRA up to the maximum (assuming you qualify)
- Backfill your 401(k)/403(b) to the maximum amount
- Roth IRA (if you don’t qualify for a traditional IRA)
- A 529 account
- Health savings accounts
- U.S. Series I savings bonds
- MLPs and muni bonds
- Taxable investments
If you have a spouse, you would also invest in the same order for their accounts (if all options are available) as you would for yourself. Based on your needs and goals, the order may vary slightly. You may also choose to skip a step because of various reasons or poor investment options. (Keep in mind: For your specific investment needs, you may want to consult your accountant and/or a financial advisor.)
The basic gist of this list is to invest first in items that give you the greatest tax reduction or tax delay. Let’s go over the steps 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 401(k), you usually get two forms of “free” money. First, your AGI (adjusted gross income) is lowered, which effectively lowers your income at least for federal taxes. Second, most companies will match your contributions up to 3-6% of what you earn. 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 don’t have cheap index-based mutual funds (e.g., Vanguard) or have only a limited selection of funds. But on the bright side, at least you are getting a 100% automatic return if your company matches what you invest.
If your company doesn’t offer matching, you might want to skip this step and revisit it during Step 3.
Now, since the Bogleheads released their list, Roth 401(k)s have hit the scene. Many companies are now offering these vehicles, which can be very efficient and effective. Unlike with Roth IRAS, there are no income limitations for contributing. And they offer higher contribution limits — for 2017, $18,000 or $24,000 if you’re age 50 or over.
2. A Traditional IRA up to the Maximum
For 2017, the maximum contributions for a traditional IRA remain the same at $5,500 per year ($6,500 if over 50). Invest the maximum amount.
Traditional IRAs are just like 401(k)/403(b)s because they are tax deferred. The greatest benefit is much more freedom in investment choices. Unlike your employer’s plan, you are limited only to the investment options offered by the firm you open an IRA account with. With IRAs it’s possible to buy anything from 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 $62,000 and $72,000 of adjusted gross income.
- For married filers who are covered by a company retirement plan, the deduction is phased out between $99,000 and $119,000 of adjusted gross income.
- For married filers who are covered by a company plan but whose spouse is not, in 2017 the deduction for your spouse is phased out between $186,000 and $196,000 of adjusted gross income.
3. Backfill Your 401(k)/403(b) to the Maximum Amount
After filling up your traditional IRA account for the year, it’s usually best to go back and backfill your employer’s retirement account to the maximum. For 2017, 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 on how bad the available funds within your retirement account are. I once worked for a company that offered only managed funds with very high annual fees (2%-plus) and had a choice of only six different funds, which all performed poorly. In my case, I invested only up to the matching.
4. Roth IRA (optional)
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 don’t 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 phaseout ranges for 2017 are:
- Single filers: Up to $118,000 (to qualify for a full contribution); $118,000–$133,000 (to be eligible for a partial contribution)
- Joint filers: Up to $186,000 (to qualify for a full contribution); $186,000–$196,000 (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 the account can be inherited.
Usually, once you reach the IRS income limits listed above, you cannot contribute to a Roth IRA. However, 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’s possible you don’t qualify for a traditional IRA. If this is the case, a Roth IRA is your next best option. To more 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 (e.g., international stocks), an IRA account should be used to fill in that gap.
5. A 529 Account
If you have children or have future higher education needs yourself, it’s best to invest money in 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 as well. Not all 529 plans are created equal, so it’s important that 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 plans. Retirement plans should always be funded first since you can’t 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 (HSA) is an excellent way to get a tax deduction for medical expenses and take advantage of tax-efficient investing. An 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 upfront. 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-it-or-lose-it. Plus, 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. U.S. Series I Savings Bonds
As I’ve previously written, I’m a big fan of U.S. Series I savings bonds. I think they’re a great way to invest some money that’s indexed to inflation and yet is tax deferred while holding the bond.
They can serve multiple purposes in your portfolio (e.g., emergency funds) and can be used for higher education needs tax-free. At minimum, invest a few thousand annually. The maximum allowed is $10,000 per Social Security Number, plus an additional $5,000 in IRS refunds per Social Security Number. They can be a used as part of your retirement bond portfolio.
Deciding to invest in Series I bonds also depends upon the fixed-rate component and other investment opportunities. Right now, the composite rate for bonds issued between May 1, 2017, and Oct. 31, 2017, is 1.96%. It will at least keep up with the CPI rate.
8. MLPs and Muni Bonds
These are optional investments, since they depend on your income level and how complex you want your tax situation to be. master limited partnerships (MLPs) are a great way to get a steady return, with most of it tax deferred. The disadvantage to MLPs is they are much more complex to deal with when filing your taxes. It’s usually recommended that you hire an accountant to properly file your taxes when owning one.
Investing in muni bonds depends upon your income level and the state where you live. High-income individuals can usually best purchase these bonds. The higher your income, the higher your effective returns are with munis, because the returns are not taxed.
If you have enough money ($200,000+), 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 goals other than retirement and higher education (e.g., 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 mostly in 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, as with any aspect of investing, one should not invest solely for tax avoidance. Do not miss investment opportunities just because it’s tax inefficient, although 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.