Part 0: Intro to Tax-Efficient Investment Vehicles

TL;DR: Take advantage of tax-efficient retirement plans to maximize your returns.

Normally when you invest, you must pay taxes on your gains. However, there are various ways to get around this. One of the most popular and recommended ways is through retirement plans such as the 401k or IRA. You can open these with various brokerages such as Fidelity or Schwab.

1. So, what are the 401k or IRA?

In both 401k’s and IRAs, they are plans where you contribute some amount of your income in, and you investment the money in these plans. The investments within these plans grow tax-free. However, there are contribution limits. In 2018, they were $18.5k for the 401k and $5.5k for the IRA (or about 25% more if you’re 59.5 or older). The catch is that you normally cannot withdraw this money until you’re 55 or 59.5, around when you’re presumably retired. These plans were made as incentives to save for retirement, which I think is good anyway. My rule of thumb is if you can afford it, contribute the maximum (or however much you can).

The kicker is to check your employer benefits. They usually have some kind of matching program for the 401k. Take advantage of that too.

A Difference Between the Two Plans: Other than the contribution limit, another difference is that 401k investments are limited to mutual funds, whereas IRA investments are much more flexible. (e.g. you can invest in any mutual fund, stock, ETF, etc… you want).

2. Roth vs. Traditional

If you’ve tried signing for one of these accounts, you know each of the 401k and IRA come in two different flavors: Roth or Traditional.

The main difference is that with the Roth 401k or Roth IRA, you contribute post-tax, i.e. you pay taxes when you contribute, and you withdraw your money (probably at retirement) tax-free. Whereas with Traditional accounts you contribute pre-tax, and you get taxed when you withdraw.

Example:

Traditional IRA: You get a paycheck and it has taxes withheld. You contribute $5.5k to your Traditional IRA. When you file your taxes for that year, you can claim a tax credit for what was withheld on that $5.5k. (Note that you can also play “catch up”, and say, contribute that 5.5k March of 2018 for the year of 2017, right in time to file your taxes in April of 2018 for the the 2017 tax year. However, you should consult a tax professional if you plan on doing this).

Roth IRA: You get a paycheck and it has taxes withheld. You contribute $5.5k to your account.

So given that, how do you choose?

Normally you’d choose Roth accounts if you perceive to be in a higher tax bracket at the time of withdrawal. That would mean if you perceive yourself to be earning more, or seeing taxes rise in the future. You’d choose Traditional accounts if you perceive yourself being in a lower tax bracket at the time of withdrawal. That means taxes falling in the future, or if you’re earning more now.

Once you know that, it’s up to you which one you’ll choose. (You’ll also want to see if your employer has a matching program in one type of 401k but not the other; that might influence your choice a lot). If you’re indecisive, you can end up choosing both (but the limits are strict for each of 401k’s and IRAs. i.e. you can only contribute $18.5k in total to both the Roth 401k and Traditional 401k if you have both).

3. Pitfalls, and Solutions

It turns out you can’t have a 401k and also take advantage of the tax credit that comes from investing in a traditional IRA.

No problem, you invest in a Roth IRA instead.

However, with Roth IRAs, if your annual income is above 120k (or 189k if married), your contribution allowance is reduced. If your income is more than 135k (or 199k if married), you cannot contribute at all.

Solution: the backdoor Roth. You simply contribute to a traditional IRA, wait a few days, then convert it to a Roth IRA (Yes, you can do that!). And that should just work.

4. Going Further

There’s a lot more to be discussed about these plans, e.g. ways to withdraw money earlier without penalties. There are also other tax-efficient plans to talk about, such as the 529 (a vehicle where investments grow tax-efficiently, and you can withdraw funds to pay for a dependent’s education), or the host of universal life insurance policies (these include whole life insurance, variable universal life, and indexed universal life insurance. Think a plan you contribute to that acts as both life insurance, but also invests in bonds or stocks, and pays out distributions at a time you specify). However, these will be discussed in later articles.

Happy tax-efficient investing!

TheJKW