Project Description

Most know they need to save money. Whether it is for an emergency, retirement, or some other goal, saving is essential. One of the big decisions in the planning process is what vehicles you should save in. Should you use a traditional 401(k)/IRA or Roth 401(k)? Should you use a 529 plan? What about an HSA? What other types of accounts should be used to save on taxes?

Introduction

What types of vehicles you choose to save is one of the most important parts of your financial plan. It affects everything from your liquidity to how much you pay in taxes. If you’re using the wrong types of accounts for your individual goals and needs, you will pay more in taxes, either now through the years, in retirement, or more commonly all of the above. On the flip side, efficiently using the right vehicles for your savings needs will save you immensely in taxes. Remember, the cost of taxes is the heaviest anchor to building wealth.

There are a couple of important notes to keep in mind. First, this part of the planning process is not about how the money should be invested. That comes after we’ve decided what the purpose of the money is and what vehicles will be used. This article will focus primarily on the vehicles and how we should prioritize those. Second, every situation is different. There will always be exceptions to the general rules regarding finances.

When it is all said and done, all of my clients are working towards efficient tax-diversification. Just as important as diversification with your investments, tax diversification allows for greater flexibility and tax savings, especially in retirement. However, sometimes it’s not possible to save the maximum amount in every tax-favored vehicle; sometimes we must choose where to save first. This article is meant to give you some general guidance on what vehicles should be prioritized over others.

Tax Treatments of Different Vehicles

In an effort to encourage Americans to save for important life events (i.e. retirement, college, health-related), the government has created a number of different types of tax-favored vehicles. Each vehicle has its own set of rules, which affect its pros/cons given a particular goal or purpose.

There are four main types of tax treatments: taxable, tax-deductible, tax-deferred, and tax-free. For many, the type of tax-treatment they select is 100% dependent on the goal that is targeted (paying for health expenses via an HSA). However, it is important to keep in mind that just because a vehicle is primarily used for a certain purpose, doesn’t mean it can only be used for that purpose.

For example, 529 accounts can also be an estate planning tool, HSA accounts can be a great retirement vehicle. I’ve even created a plan where part of an HSA may be used to purchase real estate in 20 years. I’ve also created plans where contributions to a 401(k) are done to accomplish mid-term goals. My point is, when it comes to tax planning, one should always be willing to think outside the box.

Taxable

Taxable accounts are just as they sound, taxable. Think your savings account at the bank or a taxable brokerage account. The number one advantage with them is flexibility and liquidity. Taxable interest, non-qualified dividends, and short-term capital gains are taxed at your ordinary income rates (10% – 37%). Qualified dividends and long-term capital gains are taxed at the lower capital gain rates (0%, 15%, or 20%).

The number one disadvantage to taxable accounts is the fact that, well, they are taxable. Those taxes eat into your returns and cut into your ability to grow your wealth. With that being said, one should keep in mind that in many cases, having money in taxable accounts can be more tax-advantageous than tax-deferred account. Sometimes it really comes down to running the numbers.

Tax-Deductible

The term tax-deductible means that you are able to claim a deduction for all, or some, of your contributions (think 401(k), IRA, or HSA Contributions). This effectively lowers your taxes by your marginal tax rates. For example, if you’re in the 32% tax bracket, a $6,000 IRA contribution will lower your taxes by $1,920.

Tax-Deferred

Tax-deferred means that growth within the account is not taxed. With limited exception, each tax-favored vehicle is tax-deferred. Naturally, taxable accounts are not included in that category.

Tax-deferral has huge economic value. It allows you to earn more growth on what you would otherwise pay in taxes. The longer the money is growing in a tax-deferred account, the greater the overall benefit.

Tax-Free

With tax-free accounts, the distributions from the account are completely free of taxes. Roth IRAs/401(k), 529 plans, and HSAs are considered tax-free vehicles. Of course, each of them has their own set of rules in order to qualify for tax-free status.

Priority #1 – Health Savings Accounts (HSA)

The reason why HSA accounts are the top priority is fairly simple. They are considered to be the only “triple tax-free” account. Contributions are tax deductible, growth is tax-deferred, and distributions are tax-free if used for qualifying medical expenses.

HSA’s are one of the best vehicles for retirement planning. Of course, in order to contribute to an HSA, one must have a health insurance policy that is HSA eligible. If you are not currently eligible then you should weigh the cost/benefits with your adviser to see if it’s worth switching over (if that is a possibility).

While most of my clients use HSA accounts as part of their retirement planning, I have used them for a variety of different purposes, including a temporary vehicle for emergency savings.

Priority #2 – Double-Tax-Favored Retirement Accounts, Deferred Compensation, & 529 Plans

While the HSA is triple-tax-favored, both Traditional and Roth retirement accounts are double-tax favored. Traditional retirement accounts are tax-deductible and tax-deferred (distributions are taxable). Roth retirement accounts are tax-deferred and tax-free (contributions are not deductible).

Whether you should be prioritizing Traditional or Roth contributions varies by individual. Generally speaking, high income earners should prioritize Traditional contributions over Roth. Young savers, who believe income their income will increase, should generally favor Roth over Traditional.

The reality is that a Roth retirement account only “wins out” against a Traditional account if the tax rates at the time of distribution are higher (or equal to) the tax rates at the time of contribution.

*Side-note: If you are assuming that your tax rates in retirement will be the same as your rates at contribution and returns are equal, Traditional accounts will have the same results as Roth accounts.

Deferred compensation arrangements for high-income earners fall into this category as well. The ability to defer income is similar to being tax-deductible.

Assuming that saving for children’s college is a goal, 529 plans should be priority as soon as reasonably possible. The benefits of being tax-free are enhanced the longer the money is compounding inside the account. Contributions to a 529 for a 15 year old are far less valuable as contributions to a 3 year old.

Priority #3 – Tax Free Roth Accounts (Backdoor if Necessary)

While Roth accounts generally belong in the 3rd priority, there are various factors that may result in a bump in priority. For example, if one is trying to build Emergency Savings or other Short-Term Reserves while still contributing to retirement accounts, one may decide to use a Roth account as a temporary Short-Term reserves vehicle. The advantage of this is that you only have so much that you can put into a Roth and the tax-free nature makes it advantageous to start earlier than later, even if there’s a chance you’ll need to use the money. Again, exceptions like this are always case-by-case.

Depending on the overall tax planning of the individual, traditional retirement conversions to Roth accounts may also be a part of the equation.

Priority #4 – Deferred “Mega Backdoor” Tax-Free Roth Contributions

Mega Backdoor Roth Conversions are when an employee makes elective salary deferral above and beyond the traditional limit ($19,000 in 2019) into their 401(k). If eligible based on the particular 401(k) plan documents, an employee may be able to contribute an additional $37,000 (in 2019) in after-tax deferral to the 401(k) plan. The additional after-tax contributions are then converted to a Roth once the money can be rolled out of the plan (ideally as an in-service distribution).

There are significant caveats to this strategy, eligibility, and all pros/cons should be discussed with an adviser, preferably one that excels in tax planning.

Priority #5 – Basic Tax-Deferred Growth Vehicles (e.g. variable annuity)

This priority level involves the vehicles that do not offer tax-deductions or tax-free distributions but do allow for tax-deferred growth along the way.

The most common is a non-qualified deferred annuity. Another common example is cash value life insurance.

There are a number of issues with using these vehicles. First off, although tax-deferral can bring huge economic value, it is generally best realized when paired with tax-deductible contributions or tax-free withdrawals. Here is why:

When you withdraw out of a tax-deferred vehicle (such as a variable annuity), the growth is taxed at ordinary income rates. While the vast majority of growth in a normal taxable brokerage account is taxed at capital gains rates. For example an individual in the 32% income tax bracket would only pay a capital gains tax rate of 15%. Thus, I often see people who purchased a variable annuity only to end up paying more taxes in retirement at a higher rate. While the benefits of tax-deferral can reduce that negative effect, a situation like that would take over 30 years for the benefits of tax-deferral to offset the higher tax rate on distributions.

The other common issue with basic tax-deferred vehicles, such as deferred annuities and cash value life insurance is that they tend to be products that pay high commissions to the agents that sell them and they also tend to carry very high fees with them. Those fees and commissions must be taken into consideration as more often than not, they can potentially wipe out the benefit of tax-deferral altogether.

For my clients that do need tax-deferral, we will use a very low cost variable annuity that is only $20/month, regardless of the account balance.  We then manage the investments carefully to ensure the vehicle provides synergy with the other assets within the investment plan. Even with the option of such a low cost vehicle, we must always be sure that we are not going to fall into the tax-trap of deferring taxes just to pay more in retirement.

Priority #6 – Maximizing Family Wealth and Minimizing Estate Taxes (e.g. Grantor Dynasty Trusts

With the recent increase in Lifetime Estate and Gift Tax Limits, fewer people have the need to take drastic steps to minimize estate taxes. However, for those that do, dynasty trusts can provide significant value.

The concept of a dynasty trust is that it is a trust designed to last for multiple generations. This is normally done by utilizing some or all of both the lifetime gift tax exemption and the generation-skipping-tax exemption to allow assets placed into the trust to avoid future estate taxes.

As with many trusts that are for minimizing estate taxes, dynasty trusts are not necessary an income tax savings vehicle. They are meant to cut the bite on the much more significant estate tax bill.

 

Important Thoughts Regarding Emergency Savings and Other Short-Term Reserves

It is very important to recognize that the number one priority in a sound financial plan is to establish your necessary emergency savings and other needed short-term reserves. Other short-term reserves may include: job mobility funds, business reserves, real estate investment reserves, etc.….

It may not be necessary to stop everything and focus 100% on Short-Term Reserves. In fact, that may be unwise depending on your situation. However, this cannot be neglected. An inadequate foundation can potentially destroy your wealth and potential legacy.

Fortunately, with good planning, you can accomplish your goals and provide the necessary security of a solid foundation. When done properly, it may be beneficial to use some of the various tax-favored vehicles as Short-Term Reserves until you’re able to build up what you need in a taxable account. Again, those are exceptions and must fit into your overall plan.

A Note Concerning Exceptions

As with anything financially related, your situation is completely unique to you. There are countless variables that may affect what you should prioritize. Whenever I am tax planning for a client, I always follow these 7 rules:

  1. Current Needs & Goals

Your current needs and goals must be prioritized. For example, if an option interferes with your business goals, then it should likely be immediately set aside.

  1. Future Needs & Goals

It’s easy to consider your short-term needs & goals; yet having a vision of the future is important too. This helps us to avoid costly mistakes.

  1. Current Year Tax Savings

This is simple, how much will this option save you on taxes this year? What about option B? And so on…

  1. Lifetime Tax Savings

This is where it gets trickier. One must be careful not to save money on taxes this year, just to pay more down the road. Conversely, we may be willing to pay more taxes this year if it means greater lifetime tax savings. The concept of opportunity cost and time value of money becomes very important here. Estate taxes, when applicable, should also be considered within lifetime tax savings.

  1. Liquidity Needs

For some, this is the most important factor. How much liquidity do you need? This may be for an emergency, for your emergency, possible investments, or just for reserves. Sometimes we’re willing to sacrifice some or all liquidity for tax savings. Generally speaking, with the tax planning that I like to do, I always favor achieving the most tax savings while maintaining the most possible liquidity. This is especially true for business owners and entrepreneurs.

  1. Flexibility

While sometimes we simply accept that we may lose a certain amount of flexibility with our future decisions, we will always place an emphasis on options that provide optimal flexibility in future years. In other situations, maintaining flexibility becomes non-negotiable. This flexibility comes down to what are the options/costs if circumstances change to require change in the strategy, or even make it non-viable altogether.

  1. Income & Tax Control

With added flexibility comes greater control. However, I do separate the two because I want to place a greater emphasis on how an option may give us greater control over our income. Often times this control over our income or deductions can allow us to realize significant tax savings throughout our lifetime. This isn’t just in terms of how much in deductions we’re taking, but also when we’re doing it. With proper tax planning, we’re not just thinking about this year. We’re also looking at the big picture to save the most money overall.