The core premise of tax planning is to lower your lifetime tax bill.
Not only paying less taxes today — but paying less taxes in subsequent years.
This is done by avoiding the myopia associated with filing a tax return and being thoughtful of the unintended tax consequences of your investment decisions.
Meaning
Instead of thoughtlessly jamming dollars into a pretax account (IRA or 401k) to avoid tax today — you’re also considering the impact those dollars will have on your tax bill years into the future.
Further you’re thoughtful around how the assets in your investment accounts are being managed and consider the following:
Tax loss harvesting to create tax deductible capital losses.
Municipal bond investments to avoid federal income tax on interest being earned.
Charitable giving to avoid realizing taxable gains on appreciated assets (this also will reduce your taxable income).
Fund-Account type alignment to manage taxable capital gain distributions more effectively.
And much more…
Candidly to consistently accomplish these outcomes can be time consuming and are often a reason to seek professional help.
That said, here are a few “rules of thumb” that will help you get pretty far on your own.
Roth vs Pre Tax 401k
I’ll likely do a separate blog post outlining the tradeoffs between funding a Roth or Traditional (Pre-Tax) 401k, but for the purposes of this one I simply advocate:
Funding a Pre-Tax 401k in your peak earning years, and a Roth 401k in any other one.
Admittedly it’s near impossible to determine when you’re at “peak earnings.”
Hopefully you make more and more money every year for the rest of your life.
That said, for most of us we’ll get paid more than we’ve ever been paid in our 50s.
From my experience being 50+ means:
You have decades of experience in your respective field.
You’re usually senior at your company (or a significant stakeholder)
You may sit on a few boards and do consulting.
You’re entering the “hockey stick” of your net worth.
It is at this point where electing to make tax deductible contributions to your retirement account is most sensible given that you’re likely generating more income now than you will in retirement.
Avoiding excess cash in your savings
The “cash is trash” idiom is usually associated with the fact that inflation adjusted returns for cash (over the last 100 years) are zero.
If you let a significant portion of your net worth sit in cash you will not build wealth (fact).
Further cash is the least efficient place to invest your money from a tax standpoint.
The interest income cash generates is taxed at our highest marginal tax rates — so if you’re married (filing jointly) making over $500K/year, that income is getting taxed at 38.8%.
The 100 year returns for cash when adjusted for inflation plus taxes is -1%.
Alternatively, if those funds were sitting in an index fund earning the same amount, you’d be getting taxed at 23.8% (contingent on long term capital gains treatment).
So the solution here is to keep no more than 6-12 months of needed expenses in cash while getting the rest of your money invested as frequently as possible.
Maximizing your HSA
It is rare that the IRS will offer us a tax break on the front end without them trying to recoup later on (think of the trade off on any tax-deferred account).
Yet as healthcare costs continue to sky-rocket, they’ve laden Health Savings Accounts with tax incentives to help alleviate the burden.
Here is the TLDR
The money you put into an HSA is tax deductible.
The money you put into an HSA grows tax free.
The money you pull out of an HSA is tax free (as long as it’s for qualified medical expenses).
This account is arguably the most tax efficient place to invest your savings, given that more likely than not you will need to use it for healthcare costs now or in retirement.
As long as you qualify (you need to be enrolled in a High Deductible Health Plan)… I’d consider maxing this account out every year.
Cheers