Taxes are an inevitability of life. As long as I’m living, I will be paying them.
And for the most part, I’m proud to pay taxes.
Our social security system has supported my grandparents’ and parents’ transition into a comfortable retirement. I’m privileged to live in a community with paved roads. My kids attend an incredible public school. And I feel safe knowing our military, police, and fire departments are watching out for us in times of crisis.
I agree with Mark Cuban when he said, “While some people might find it distasteful to pay taxes, I don’t. I find it patriotic.”
But just because I agree with the idea of paying taxes for the betterment of our society, doesn’t mean I want to overpay them. If I’m given the opportunity to keep more of my hard-earned money and have it work hard for me, I’m game.
Here are some ways we have invested with tax efficiency in mind.
Ready to improve your own tax-minded investing? Check out the guide 5 Tax Hacks Every Investor Should Know, a compilation of insights from Personal Capital’s financial advisors.
Traditional 401k Contributions
Starting in 2014, I maxed out my traditional 401k for seven years straight.
This allowed our family to defer tax payments on between $17,000 to $19,500 (depending on the year) of income each year.
(For reference, the maximum 401k contribution for 2021 is $19,500 with an additional $6,500 contribution allowed for those turning age 50 or older to catch up.)
With a lower taxable income today, our family has had the benefit of paying fewer taxes (legally) today.
Read More: How to Reduce Taxable Income: Can the Average American Pay No Taxes?
Additionally, my employer matched 15% of my contributions to my 401k. When I contributed $19,500, they provided $2,925 of “free money.” That employer match, my earnings (interest, dividends, and capital gains), and any further contributions are also tax-deferred.
The key word here is “deferred.” We will have to pay taxes on this money eventually. And with the current federal debt hovering around $28 trillion and rising, this massive tax bill will come due someday soon.
Roth IRA Contributions
To diversify my family’s tax burden, I have been investing a lot more into “Roth” vehicles lately. These are after-tax investments that allow you to pay the tax on your income today but offer tax-free growth of your investments.
While there are important differences between a Roth 401k vs Roth IRA, both serve a similar purpose: tax-exempt investment growth.
Both my wife and I have a Roth IRA, and we’ve been contributing to our accounts for over a decade. The Roth IRA requires an earned income, but even when my wife decided to stay at home with our kids, she was able to contribute to her account. A nice perk for sure!
During our wealth-building journey, there were certain years when we were ineligible to contribute to a Roth IRA due to the income limits. When that was the case, we took advantage of what’s called a Backdoor Roth IRA to keep the tax-free growth going.
With some of our investments in traditional vehicles (pre-tax) and some in Roth vehicles (after-tax), we’re feeling more comfortable. Depending on our tax bracket in retirement (and the state of tax situation in the U.S. at the time), we’ll be able to adjust accordingly when it comes to selling off our investments for income.
Health Savings Account (HSA)
One of the most underrated investment vehicles out there is the Health Savings Account (HSA). Often confused with the FSA, the HSA can get dismissed as a limited workplace benefit option. That is definitely not the case.
Read More: HSA vs. FSA – An Overview
Currently, we’re using our HSA as a way to save for everyday health care expenses, invest for long-term health care costs, and if we’re lucky, enjoy the leftovers for retirement.
When it comes to tax efficiency, the HSA packs a triple-tax advantage that is hard to deny.
- Pre-tax contributions (with your employer sponsored plan) or tax-deductible contributions if you’re employer does not have an HSA option
- Tax-free withdrawals as long as you use the funds for qualified medical expenses
- Tax-free growth when the money is saved or invested
So far we’ve socked away around $15,000 in our HSA. With time, compound interest, regular contributions, and a little bit of luck on our side, we should have a sizable amount of money waiting for us. And with the cost of healthcare steadily rising, this is a tax-efficient investment strategy we’re enjoying right now.
529 College Savings
Our kiddos haven’t hit “double digits” yet, but by the time they reach college age, the costs will likely be in the “six digits!”
If my daughter decides to attend my alma mater, Michigan State University (ahem, go green), we’re looking at over $200,000 for four years of college starting in the year 2030, according to this handy calculator. We are nowhere near that amount now, but we’re working on it with a little help from our 529 College Savings Plan.
Not all states have a state income tax deduction for 529 contributions. Luckily, our great state of Michigan does. This is just one more way we can invest with tax efficiency in mind.
In addition to the state income tax deduction, our after-tax 529 contributions grow tax-free. Over the last nine years, our daughter’s 529 balance has grown to around $50,000. Around half of that amount consists of tax-free earnings. That sort of tax benefit makes me smile.
Final Thoughts on How We Invest With Tax Efficiency in Mind
We’re not able to escape taxes entirely, but we can learn to live with them and reduce them when possible.
I mentioned just a few tax efficient options. Depending on your income, your stage in life, and your goals, there are other routes to consider as well including:
- Self-Directed IRAs
- SEP IRAs (Simplified Employee Pension)
- Solo 401k
- 457 or 403(b)
- SIMPLE IRAs (Savings Incentive Match Plan for Employees)
Oftentimes people consider housing, transportation, and food as our largest expenses. We can forget the impact of taxes and how it affects our present and our future.
I do feel a sense of pride and patriotism paying my taxes, but I definitely love saluting my frugal flag as well.
One last tip: Check in with the professionals. Personal Capital’s financial advisors put together their list of five top tax hacks in a downloadable guide. When you get the guide, you also gain access to Personal Capital’s award-winning financial tools. Millions of people (myself included) use these tools for analyzing investments, uncovering hidden fees, and planning for long-term goals like retirement.
Personal Capital compensates Andy Hill (“Author”) for providing the content contained in this blog post. Compensation not to exceed $500. Author is not a client of Personal Capital Advisors Corporation. The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.