Best Tax Savings Options for High Income Earners, Ep 39
Today we're going to talk about one of my favorite expressions 'It's not what you make. It's what you keep.' I'm going to borrow from a tremendous blog post that Michael Kitces wrote some time ago. If you're not familiar with Michael he's one of the big thinkers in my world of financial planning. He puts out a ton of wonderful material. If you want to nerd out, you have to check out his blog. The title of the blog post I want to dissect is 'The Hierarchy of Tax Preferenced Savings Vehicles for High-Income Earners', not sure about the grammatical correctness but it’s a fantastic article. My financial planning and investment management firm caters to equity compensation owners who are typically high-income earners so Michael's article makes me feel like I am in good company since we both prioritize tax savings for high-income earners in the same way.
You will want to hear this episode if you are interested in...
- The two categories of tax preference accounts [1:51]
- The HSA [2:33]
- Tax preferred vehicles that have doubled tax-preferred components [5:59]
- The Backdoor Roth [8:27]
- The Mega Backdoor Roth [11:05]
- Tax-efficient investing [12:48]
- This week’s FLASHBACK [14:41]
The two tax preferenced account categories
Tax preferenced accounts come in two main categories. The first is the traditional type where contributions go in before taxes. These include things like your IRA or 401k. While you don't pay taxes on the front end, you will have to pay them upon distribution as they come out taxed at ordinary income levels. The second type is the Roth style, which is the opposite. Contributions to these accounts are taxed ahead of time and their distributions are tax-free. Assuming you follow the distribution rules, which are pretty straightforward. Both of these two types enjoy tax-free growth.
The order of tax-preferred investments
As you invest there is an order that makes the most sense from a tax savings perspective. Picture a pyramid with the most tax-preferred vehicle at the base. At the base you have the good old Health Savings Account. The HSA combines the best of the aforementioned tax preferences. The next level is going to be your combos. Combo 1 is your IRA’s and 401k’s contributions here go in before taxes, grow without taxes, and are taxed upon distribution. Combo 2 is the opposite. It's the Roth type of accounts where the money goes in after taxes, grows without taxes, and comes out without taxes. The third level of the pyramid is the Backdoor Roth. If you are a high earner you may make too much to do a regular Roth IRA contribution. If you max out your 401k and HSA accounts for the year and still want to invest, the IRS permits you to do a Backdoor Roth. If it applies, the Mega Backdoor Roth might be an option as well. The fourth level deals with after-tax money, primarily tax efficient investing. An investment strategy that's taking advantage of tax-loss harvesting, not creating a ton of taxable income through dividends, not trading a ton, and creating taxes and fees. The final level of the pyramid starts moving into the world to have conversations with your estate planning attorney to talk about grantor dynasty trust. Listen to the episode for a more in-depth discussion on each of these levels.
This week’s FLASHBACK: Useless GenX trivia - Back to the Future
Today's flashback is a useless piece of GenX trivia. Back to the Future is a classic from the '80s. I learned recently that most of the filming happened at night and on weekends because Michael J. Fox was doing Family Ties at the same time. He would film Family Ties during the day and then the movie at night. Daylight scenes for Back to the Future were filmed on weekends. I guess Michael J. Fox didn't want to let the opportunity pass him by. He was in the middle of his contract with Family Ties and fortunately, everybody was nice enough to accommodate him. The director of the film, Robert Zemeckis, referred to it as the film that wouldn't wrap, since they had limited hours they could film and it took longer than they expected. Glad he was able to do it and they got it together because it's one of the classics from the eighties.
Resources & People Mentioned
- Michael Kitces
- The Hierarchy of Tax Preferenced Savings Vehicles for High Income Earners
I’m Dan Johnson, CFP®, founder of Forward Thinking Wealth Management. I run a flat-fee financial planning and investment management firm located in beautiful Akron, OH. Although I am in Akron, OH, I work with clients regardless of location. I cater to owners of equity compensation positions who are looking to organize their financial lives, keep more of what they make, and do the things they want in retirement and even now.