Hierarchy of Tax Savings Vehicles
Let’s talk quickly about what is referred to in my world as the “hierarchy of tax-preferenced savings vehicles.” I believe I wrote about this before, but here is an abbreviated version as I will not be getting into things like trusts. Finally, this is a quick read at 3 minutes.
What is this?
- These are some various ways to save for the future and also save on taxes.
- You know me – It’s not what you make; it’s what you keep.
- Some investment vehicles are more tax-efficient than others. And some are overlooked.
- Here we will hit the highlights of ways to save for retirement and not tip Uncle Sam.
- Imagine this being a pyramid, with the most important at the bottom.
Order of Priority:
- At the base of the pyramid is the Health Savings Account. This is triple-tax free. No taxes for contributions. None on growth. No taxes on distribution as long as it is for medical-related expenses. Study after study shows if you were to max out one account this would be the one. 🤑
- Reminder with HSAs – you must invest the account balance. I see this so often. People make their HSA contributions and then the funds sit in cash. No bueno! 😲
- Next I am combining two into one – IRAs and 401ks. Here the contributions go in before taxes and grow without taxes. Distributions are treated as ordinary income.
- Another reminder here. Pay taxes when they are the lowest. Remember this as we touch on Roths.
- Roths, including Backdoor Roths and Roth 401ks are the next level of the pyramid. These are the opposite of IRAs and 401ks. Money goes in after-taxes, grows without taxes and then is tax-free upon distribution, assuming you followed the rules. Be careful here as there are time-periods attached to the different types of Roths.
- Roths and traditional IRAs may flip their placement on the pyramid depending on whether your taxes are higher now or in retirement. Again, this is if you follow the thought of paying taxes when they are the lowest.
- Finally, we have taxable accounts. I mentioned this recently in an article about mutual funds in taxable accounts. With taxable accounts the money goes in after taxes, growth can be taxed, and taxes upon distribution. Be thoughtful with the investment choices within taxable accounts.
- There are other layers of the pyramid that start pulling in annuities and trust work.
- I am not getting into the weeds on those, but be aware there are other options available.
Why This Matters To You:
- Taxes are not getting lower. Heck, they are actually rather low right now.
- In less than three years tax rates are going up. This assumes no changes at the Federal level.
- I focus a lot on tax planning for a few reasons. First, not to tip Uncle Sam. That is a bit of a trite expression, however, there is a more important reason to focus on tax mitigation. Once you lose principal due to bad tax decisions that principal is GONE!!! 😭 😭 😭
- Being tax smart will help the funds stay in your account and growing for your future.