My Tax Efficient Investing Plan
If the Mayans are wrong and Dec 21, 2012 doesn’t bring the end of the world, taxmageddon is still headed our way in 2013. Income taxes are slated to go up for every single tax-paying American unless congress and Obama act. Regardless of whether you’re for or against the proposed tax increase, it’s causing a lot of uncertainty among investors. This tax increase would return the capital gains tax to ordinary income rates, greatly affecting investors and their retirement accounts.
The budget deficit is growing every year, so it seems pretty reasonable that there is only one direction taxes can go, and that’s up. With that in mind, it’s important to know how your money is taxed going into retirement accounts and how it might be taxed coming out. Capital gains taxes can have a significant impact(just ask Mitt Romney) over a long horizon. There are different theories as to the most efficient fund placement but I like to keep it simple.
My Tax Efficient Investing Plan
1. 401k – Contribute up to the maximum employer match
2. Traditional IRA/More 401k – It’s easy to contribute more to your 401k but if your plan is laced with fees, consider opening a traditional IRA.
3. Roth IRA – Allows you to lock in tax rates now
4. Alternative Investments – Real estate prices are at an all time low
5. Taxable accounts – I’m not a huge fan of taxable accounts for retirement investing and I’ll explain why
1. 401k Up to the Employer’s Match
I’m lucky because my company fully matches up to 6% of my 401k contributions, with an additional 2% vested after 3 years. So as long as I stay with the company 3 years, I receive a 6% match and a 2% bonus as long as I contribute 6% of my salary. Contributing up to your employer’s match is a no brainer, even if it’s only 2-3%; it’s a guaranteed return. If my company didn’t match my contributions, I’d probably skip to step 2.
2. Open a Traditional IRA or Contribute More to Your 401k
If your company doesn’t offer matching, then their investment options are probably pretty lacking too. I’d go straight to a company like Vanguard and open a traditional IRA. There you’ll get great service and some awesome ultra-low cost mutual funds. For those of you that have high fees and limited choices in your 401k, a traditional IRA can be a good choice after you’ve contributed up to the employer’s match. After you collect that free money, there’s no reason you have to stay with your 401k provider. Opening an account with Vanguard will also make things easier if you want to rollover your 401k when you leave your employer. Traditional IRA’s give you a ton of flexibility, you can invest in everything from gold and REIT’s to Lending Club.
If your 401k plan has low fees and a good selection, contribute more! I’ve increased my 401k every time I got a raise over the past three years, and now I’m max’d out. If you have an HSA, I’d also consider contributing here because it’s the only triple tax advantaged account.
3. Open a Roth IRA
I always recommend Roth IRA’s because it allows you to diversify your investments from a tax perspective in addition to reducing volatility. I think tax rates are going up and a Roth IRA allows you to lock in current tax rates unlike a 401k where you will pay taxes at your ordinary income rate when you withdraw after the age of 65. If you read this blog for the next 30 years, you should have a wide array of passive income by then and your income will be much higher than it is now
Unfortunately though, with a Roth IRA you have to contribute your after tax dollars so you don’t get the AGI reduction like with a 401k or a traditional IRA. There are income restrictions for a Roth IRA too but if your AGI is less than $110,000 you can still contribute. Alternatively, for those over the AGI limit, they can explore a backdoor Roth IRA.
4. Alternative Investments
Now that I’ve max’d out my 401k, Roth IRA and HSA, I am saving all my after tax money for my next real estate purchase. Real estate prices are still low and the interest rates are at an all time low. Real estate is the only investment where you can put up 20-30% of the investment, but still receive 100% of the returns. Not only will you receive 100% of the returns, but you don’t even have to pay taxes on the capital gains from selling your property up to $250,000.
5. Taxable Accounts
You should only consider contributing to a taxable account once you’ve exhausted all other options. And trust me there are many! Before you invest in taxable accounts, you can open a 529, buy tax free savings bonds, and more. But I think real estate is the best after tax option since it can help you create steady passive income. But if you’re insistent on after-tax investing make sure to invest in tax efficient stocks like ETF’s or low cost mutual funds.
A good retirement plan involves diversifying your investments in addition to diversifying the way they’ll be taxed. Although I think taxes will be higher in the future, they could easily be lower and that’s why I have a wide array of very different investments in my portfolio. Some of my investments pay tax now, some pay later, and some pay never.
Although every situation is unique, I recommend contributing up to the employer match, starting a Roth IRA, using your raises to increase 401k contribution, then starting tolook at alternative investments like real estate. Although there are a lot of different opinions on this subject, this is the plan I’ve used and what I always recommend. It’s worked great so far, and I’m happy to say I’m on track to retiring early while creating steady sources of passive income.
Readers, do you do some, all or none of this? Are there any types of investments I’ve missed that are a sure thing?
-Harry @ PF ProTags: 401k, KISS, Roth IRA, Vanguard