Hello everyone! Hope all is well today. I have a very fun and exciting topic to chat about today, that is of course if you are a finance nerd like me. But today’s topic is also critically important to making sure you have enough to retire! And that topic is tax-efficient investments.
It is very easy, or has been for me at least, to focus on my target number and nothing else. I know how much I have today in investments…I know what I need to get to…what else is there, right? Wrong! Hidden in my investments (and yours…) is income tax that is being deferred, but eventually we’ll have to pay it.
Sure, there may be ways to avoid or reduce this potential tax obligation, we will save that for another post. But step 1 in the process is identifying and estimating how much of our investments may be subject to income tax. Once we know how much exposure we have in investments, we can then later decide how to address it (saving above and beyond our initial Financial Independence number or taking steps / finding loopholes in the tax code to reduce it).
What are tax-efficient investments? Quite simply, these are investments that we won’t have to pay tax on in retirement or upon withdrawal. However, the more difficult part will be determining how tax-efficient investments are in each individual account (his & hers, ROTHs and traditional, etc) and also estimating the tax obligation at the time of withdrawal.
Step 1: List Out All Accounts
So let’s try to keep this simple. First, let’s start by listing out all accounts. For my wife and I, I’ve done this below:
- JW’s Roth IRA
- Lucy’s Roth IRA
- JW’s Roth 401K
- JW’s Traditional 401K
- Lucy’s Roth 401K
- Lucy’s Traditional 401K
- Our Taxable Brokerage Account (Joint)
- Our Small Business Investment
- Our Health Savings Account (Joint)
- Kid #1 529 Plan (Kid #2 doesn’t have one yet…:) )
That’s a lot of accounts! As you can see, it can get complicated quickly. That’s nine individual accounts! But if we stay focused on addressing each account at a time, we can paint a good picture.
Step 2: Divide and Conquer
Individual Retirement Accounts (IRAs)
In terms of tax-efficient investments, Roth IRA accounts are gold, true gold! Taxes have already been paid on these dollars. And I don’t have to pay additional tax on them as they grow annually nor do I pay an incremental tax upon withdrawal. This money is good to go, 100%!
JW’s Roth IRA – ~$135K total invested
- 100% Tax-Efficient Investment
Lucy’s Roth IRA – ~$100K total invested
- 100% Tax-Efficient Investment
Going forward we will continue to put the max contribution amount in our Roth IRA’s. While the Traditional IRA would likely be more optimal for us since we are in a higher tax bracket today than we likely will be in retirement, we are locked out of this option since our taxable income is above the max allowed.
However, we are still able to contribute to the Roth via a well-known tax-loophole referred to as the “back-door Roth IRA”.
The point is though, that in retirement these accounts can be accessed without having to pay any tax!
One of my mistakes and regrets was not managing my 401K contributions to Roth or Traditional accounts in the most tax-efficient manner. However, in recent years both Lucy and I have made all contributions to 401K accounts in a pre-tax manner (to our Traditional 401Ks). Similar to the rationale for the Traditional IRA accounts I mentioned above, we don’t expect to be in as high of a tax bracket in retirement as we are now.
So while the best long-term tax strategy is to defer income taxes until retirement, the downside is that the total amount invested in the 401K is deceiving in that tax will eventually be coming back out.
JW’s 401K – ~$330K total invested
- 12% Tax-Efficient Investment (held in a post-tax Roth 401K)
- 88% held in my Traditional 401k which will be subject to income tax upon withdrawal
Lucy’s 401K – ~$176K total invested
- 8% Tax-Efficient Investment (held in a post-tax Roth 401K)
- 92% held in her Traditional 401K which will be subject to income tax upon withdrawal
Going forward we will continue to be investing in our 401Ks on a Traditional basis, with pre-tax dollars. As such, the percentage of our 401Ks that are considered tax efficient investments (approximately $54K, or 10.6% of our combined 401Ks) for retirement will continue to go down relative to our total 401K.
My simple back of the envelope estimates show the 10.6% tax efficient investment (based on our combined 401Ks) will be approximately 8% in five years, or roughly $80K (growing at an estimated 7-8%).
Joint Taxable Brokerage Account
- Post-tax investment, subject to capital gains tax upon withdrawal
- 81% Tax-Efficient Investment (capital gains tax is applicable to 19%)
While we have focused on maxing out our more tax efficient IRA and 401k retirement accounts, all remaining funds available to save for retirement have been tucked away in this taxable brokerage account.
This is not a tax friendly way to invest since we have to pay tax on dollars invested (they are post-tax dollars) as well as dividend or interest income tax annually. Additionally, when I sell the investments, any gains or investment appreciation will be taxed at the capital gains income tax rate (15% for most tax brackets).
In 2016, I sold a good chunk of this account in order to invest in a small business with my siblings. As such, I reported capital gains of approximately $15K and over $2K in capital gains tax.
However, there is one benefit in this account and that is besides the annual tax I pay on dividends, the capital gains tax upon withdrawal is only upon actual gains, or appreciation in the account. I will not have to pay tax upon withdrawal on the original contributions I make nor the dividends that I’m already paying tax on annually.
Currently, I’m sitting on an estimated $24K of capital gains for the entirety of this account. Applying an estimated 15% capital gains tax and that would yield about $3.5K in tax. So I would say this account is at a 97% tax efficient investment.
And one other point to emphasize is that the capital gains I will be taxed on is at a lower rate than my income tax bracket. The capital gains tax rate has always been political, but ever since the Clinton presidency it has been set at around 15-20%. Not too bad. And even better if I’m at the 15% or lower tax bracket in retirement (upon withdrawal) as the capital gains tax rate is 0% in those brackets.
Small Business Investment
- Post-tax investment, subject to capital gains tax upon withdrawal
- 100% Tax-Efficient Investment (no applicable capital gains expected as of today)
If you’ve been following The Green Swan for a while, you know that I made a sizeable investment in a small business with my brothers last year. This is not through a tax-sheltered account such as a self-directed IRA. We looked into this option, but the investment didn’t qualify. I can’t recall all the details now, but that was the conclusion.
So nonetheless, this investment was made and any gains will be subject to capital gains tax (on the appreciated amount above my original investment). As you know from my last update on the business, we’ve been treading water lately but momentum is picking up and we are all confident in growing this business.
This account will be treated in a similar tax manner as my taxable brokerage account. With growth will come a capital gains tax bill upon withdrawal or sale of my interest, but that will be a good problem to have.
Currently I wouldn’t estimate the value to have changed much since the initial investment and therefore not subject to capital gains tax. As such, I would call this a 100% tax-efficient investment as of now.
Joint Health Savings Account (H.S.A.)
Right up there with our Roth IRAs, the H.S.A. is one of my favorite accounts. This money is invested with pre-tax dollars, the gains and appreciation are all tax free, and the funds can be pulled out 100% tax free at any time to cover medical expenses. And at age 65 funds can be pulled out for any reason although they’d be subject to income tax at that point (acting in a similar fashion as a Traditional IRA or 401K in that scenario).
However, our intent is to use these funds for health related needs at some point or another, therefore I consider this 100% tax-efficient investment.
- 100% Tax-Efficient Investment for medical care expenses
529 Plans are great tax optimized investment vehicles for the purpose of paying for college expenses. Funds are invested on an after-tax basis, but any gains or appreciation are tax free and funds can be withdrawn tax-free to cover college related expenses and tuition.
If funds were pulled out for other reasons, besides various exceptions, the funds would be applicable to a 10% penalty and taxes.
However, our intent is to use this account solely for our kids’ college expenses and therefore I consider it to be a 100% tax-efficient investment.
- 100% Tax-Efficient Investment for college expenses
Step 3: Assess How Much Your Investments are Worth to You
So…what’s it to you? How much is your money actually worth to you? Chances are you will have a meaningful amount of money tucked away into traditional retirement accounts which will eventually be subject to tax (whether income or capital gains). That’s certainly the case for me.
To help paint the picture, I threw my tax-efficient investment analysis into a matrix and created a pretty little stacked bar chart that I’d hope would make Big ERN proud (his charts are always the best…:) ).
As you can see, the tax is hidden in Lucy and my 401k accounts since those are held predominantly in Traditional 401Ks (rather than Roth or After-Tax accounts). The chart below shows the tax-efficient investment analysis on our cumulative investments.
Not too shabby, but a good chunk of our investments will be subject to some form of tax. The magnitude? Well, for fun if I would apply a 20% income tax and 15% capital gains tax, then my true nest egg on an after-tax basis would be approximately $100K less than it is today. In other words, I have approximately $100K in tax hidden in my investments that I’ll have to pay. That’s a nice small fortune there that I can’t afford to overlook.
My target Financial Independence and Retire Early (FIRE) number is what I’ve coined a Smilodon, or roughly $3 million. And based on how I plan to carry a 4×4 to secure retirement, this needs to be an after-tax (or tax free) number!
Something to think about, and definitely word to the wise for those planning to retire early. Don’t forget about tax!
So back to the question in the title…do you have tax-efficient investments? Now that I know where my tax is hidden and the type of tax my investments are subject to I can take a look at how I can plan my retirement to minimize taxes. Next week we’ll take a look at what my $3 million retirement portfolio will look like from a tax perspective, and the steps I’ll take in terms of withdrawals and rollovers to reduce or even pay no tax at all!
Thanks for taking a look!
The Green Swan