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Tax-Preferenced Savings Vehicles


Michael Kitces is one of the top big-thinkers in my world of financial planning.  He is constantly putting out great stuff.  The only drawbacks of Michael’s stuff, in my opinion, are he can get rather technical and verbose.  Heck, his executive summaries are usually longer than one of my entire articles.

Regardless, Michael put together a great and detailed post recently on the “Hierarchy of Tax-Preferenced Savings Vehicles for High-Income Earners.”  I’ve linked Michael’s original article if you want to get a deeper dive.  I thought I would take this week’s column just to give a high-level summary of his list.  So, let’s head on in.

First is what I have referred to as the Triple Crown/Triple Play/Trifecta in the past – Health Savings Accounts.  The reason is three-fold.  First, contributions are made before taxes are taken out.  Next, growth occurs tax-free.  Finally, as long as you are taking distributions for qualified expenses (medical), there are no taxes on distributions.  The only drawbacks with HSAs, and they are minor ones in the big picture, is you need to be in a high-deductible health care plan to enroll and plan administration and investment expenses are still on the high side.  If you are eligible, take advantage of HSAs before the government wises up.

The next on his list are those vehicles which offer two-levels of tax benefit.  You know, like IRAs, 401ks, Roths, and even 529 plans for college savings.  All of these plans offer tax savings on two components.  For some it is the contributions and growth happen without taxes and others it is the growth and distributions happen tax-free.  Again, assuming you use them in compliance with their rules.  You know, don’t try and use your 529 plan balance to buy that new HDTV for your basement and say it was for your kid’s dorm.

Michael would refer to this level as the third tier.  The primary vehicle here is the Backdoor Roth.  This is where you make an after-tax contribution to an IRA and then convert it over to a Roth.  There is no tax advantage up front because it is funded after taxes are taken out, however, the growth and distributions are tax-free.  These don’t get to the level of tier two because some people stop at the after-tax (non-deductible) IRA contribution and never convert to a Roth.  I have no idea why they would stop.  Also, the contribution limits are significantly lower than your 401k maximums.

Tier 4 is the Mega Backdoor Roth.  I have written about this in the past and even did a video on it.  To really learn about this, you may want to check out the www.whitecoatinvestor.com site as he has done some great stuff on it.  The biggest drawback with the Mega Backdoor Roth is I have yet to come across an employer who is set up to allow this to happen. However, I know they are out there.

Level 5 is simply tax-deferred growth.  Here you get NO tax-deferral for contributions or distributions.  However, the growth can occur tax-free.  The most common vehicle here is an annuity.  Be aware the internal costs of annuities can be higher due to riders. 

Finally, his last level involves your attorney and Grantor (Dynasty) trusts.  These trusts are typically designed for those who have accumulated significant assets and want to provide for multiple generations.  This falls into the purview of talking with your estate planning attorney.

So, very high level of another great article by Michael Kitces.  If you are interested in any of these topics specifically, I would recommend visiting his site.  As I said, he is one of the best of the big thinkers in my world.