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A Guide to Tax Efficient Investing

Tax advantaged accounts are plentiful under our current tax laws. Today I want to explore those accounts and put them in rank order in respect to tax efficiency. This comprehensive guide to tax efficient investing will hopefully help you to determine how to invest your hard earned cash in the most tax efficient way possible. However, remember as we proceed that tax efficiency is only one of multiple considerations when investing.

Before we proceed we must list my normal disclaimer.  Full Time Finance is for entertainment purposes only.  Any investing actions you take are your’s  and your’s alone.

Onto the Rankings of Tax Efficient Investing

This article came about as a suggestion from Torch Red during a recent post. It’s a continuation of my analysis on tax advantages accounts, my withdrawal strategy, and my take on 401Ks regarding RMDs.  Without further ado let’s begin the discussion of those tax advantages accounts in tax efficiency order:

  1. HSA
    Easily the best tax advantaged account out there. Deposit money now tax free, earn a return tax free, and withdrawal tax free so long as you use it for a qualified health expense. You don’t even need to utilize it for a health care expense at the time of withdrawal. Some individuals hold their expenses for years, letting the money accrue tax free, until utilizing their expenses all at once to remove their funds.
  2. 457 Plan
    If you are one of the lucky ones who works for a government organization you might have an alternate version of a 401K called a 457 plan. These plans behave  similarly to a 401K but are independent from the 401K limit. As such if you are lucky enough to be at an employer with both types of plans you can contribute your 18K employee contribution to both at the same time. A 457 also allows early withdrawal without the 10% penalty which is why it is before the 401K. Sadly I don’t have access to one of these plans.
  3. 401k
    The one most people are familiar with. You can put up to 18K a year as an employee contribution into an account pretax. Then you pay tax at the time of withdrawal. Many employers also will match a portion of your contribution. Not a bad deal and easy to automate contribution directly out of your paycheck. Additionally this amount is removed from your Adjust Gross Income calculation. What is your adjusted gross income? It’s the number the government uses when determining both your tax bracket and what deductions, credits, and other accounts you qualify for. For example at certain income levels contributing to a 401K can mean the difference between being able to contribute to a Roth IRA as normal or needing to use the Back Door Roth.
  4. Roth IRA
    One of my favorite Tax advantaged accounts. Pay Taxes on $5,500 dollars a year, then watch it earn interest tax free until withdrawal at retirement. If you are over 50 this number rises to $6,500. The only downside is the pesky income limits where this phases out for a couple begin at $186,000 and $118,000 for an individual. You can get around these limits using a Back door Roth which I mention later in this post and highly recommend if you do not qualify.
  5. 401K Taxable contribution to a Roth Conversion
    I have an upcoming post of this one. If your employer allows after tax 401K contributions and in-service roll overs this one may be for you! Essentially you can contribute a combined amount to your 401K each year, after tax, pretax, and employer match of $54K. This $54K includes your normal $18K 401k tax advantaged contribution and $36K of taxed contribution assuming you receive no match.Why would you want to do this you ask? Well you can then, in the same year, roll the 401k over to a Roth and a traditional IRA. You will need to do both due to the Pro-rata rule taking pretax to the Traditional and after to the Roth. The traditional roll will not be taxable as it will stay pre-tax. The Roth contribution has already been taxed so it will not be re-taxed. By doing so you’ve essentially contributed another $36K/year into your Roth account. If you and your spouse both do so you’re tax advantaged space will increase by $72K via this trick.
  6. Back Door Roth
    Think of this as the functional equivalent of the Roth for those who do not qualify by income. Simply enter your funds in an after tax IRA (up to $5500 for those under 50 or $6,500 for those over 50 with the IRS catchup provision). Then convert to a Roth sometime during the year. This allows you to contribute to a Roth even if you do not otherwise qualify for a Roth IRA.
  7. Solo 401K
    A while back I wrote a post on my love for the Solo 401K.  If you make any type of self employed income this one is for you. Even if you have contributed your entire $18K employee contribution through an employer 401K plan, you can still put 20% of your business income up to 54K into a solo 401K. The only reason this one is so low is because if you are making enough that 20% of your business income equals 54K it is doubtful you have a corporate job.   As such most real world results will be significantly reduced or will not be able to utilize other methods. Either way the contribution is tax free, with tax applicable at withdrawal.
  8. SEP IRA
    A SEP IRA is functionally equivalent to the Solo 401K for those whose who already contribute the max 18K employee contribution to their employers 401K. If you don’t have a separate employer 401K you want a solo 401k. Minus the option of an employee contribution the two are equal.
  9. Roth 401K
    Why so low Full Time Finance? Well, I’ve already written about ways to get almost $41K dollars a person into a Roth after tax account. Given I prefer tax diversity  I just don’t really favor dumping even more into an after tax account at the expense of a before tax account like a 401K. Your contribution to a 401k, Roth or Traditional, is considered part of your 18K employee limit.As Torch Red pointed out a week ago though, there are some advantages here over a 401K. 18K in a traditional 401K is less than 18K in a Roth, since one is post tax. Therefore the Roth does increase your tax advantaged space. I still would skip it given the other reasons, but it is a point to consider.
  10. Dependent Care Flexible Spend account
    If you have kids under 13 that require childcare so you and your spouse can work, this one is for you. An individual can contribute up to $2500 a year and a couple can contribute $5000 a year. The funds must be used in the year of contribution for qualified care for your dependents. More information can be found here. It’s only for one year which drops it down the list somewhat, but its still tax free money. I like to dump the resulting funds into an after tax account like a Roth IRA, I-bonds, or Muni bonds to maximize the long term tax efficiency. Tax free in and tax free out.
  11. I-bonds and EE Bonds
    I-bonds and EE Bonds accrue interest over their lifetime with taxes paid and maturity. If used the cash out value for a qualified education expense at the time of maturity they are tax-free. Obviously the restrictions here make this one a little less valuable. Still you can’t beat 100% tax free if you meet the requirements.
  12. Muni bonds
    Certain muni bonds, generally those issues for the state rather than by the state on behalf of some other organization, are tax exempt. Essentially you do not pay taxes on the coupon of the bond. You will pay taxes on any discount from principal. Contributions are obviously pre taxes, unless of course you do as I do and pull the cash from short term tax advantaged accounts like a dependent care flexible spend account. A note, muni bonds are usually only state tax free when issued by your state. Check the terms of the specific issue before purchasing.
  13. Debt Prepayment
    Some of you are probably scratching your head at this one. Others may be screaming about debt leverage. In either case viewed independent of rate of return comparisons, paying off debt is hugely tax advantaged. If you view a debt as a negative bond or return, paying off that debt results in a guaranteed non taxable return (or lack of a reduction) equal to the interest reduction. Note mortgage debt is called out separately here as mortgage interest is tax deductible. Paying it off early may ultimately have a negative impact on your tax rate.
  14. Traditional IRA
    Another one most people will be familiar with. These are tax deductible contributions to a retirement account where you pay taxes on the withdrawal. This one is so low for two reasons. One, you can only choose this account at the expense of a Roth IRA for your $5,500 a year contribution. I would suggest the ROTH IRA is more valuable for most. Add to that if you are married and making over $99K or single and making over $62K, then your deduction amounts will phase out, fully disappearing by $119K and $72K respectively. If you have a low enough tax bracket a Traditional IRA may come out ahead of the Roth IRA.  Also if you have no access to a 401K a Traditional IRA may be your only pre-tax option other then a HSA.  Otherwise I would only utilize a traditional IRA for the purposes of a Back Door Roth mentioned earlier.
  15. MyIRA
    Since this one essentially fills up your IRA space, eliminating the availability of a traditional IRA or Roth IRA, it falls way down the list. It’s also going away this year, so I guess most people agreed.
  16. ESPP
    Employee Stock Purchase Plans are generally a good deal. These plans allow an employee to purchase company stock at a discount of typically 15% or more. Typically the discount is applied at either the time of stock purchase or based on a look back period (typically 6 months prior). If held for 2 years after the start date and 1 year after the purchase date, at sale the tax rate becomes more favorable. Instead of paying ordinary taxes on the purchase price minus what you pay for the stock, you would pay ordinary taxes only on the discount. You would pay capital gains on any remaining portion. So you would potentially save ordinary taxes on any cost reduction due to the look back. In practice I do not recommend holding your company stock, which would mean selling immediately and forgoing any tax advantage. This is why this one falls so low.
  17. Mortgage Debt Prepayment
    Viewed solely on the case of tax efficiency, prepaying your mortgage can increase your tax bill. Each year the interest is tax deductible. Thus reducing your balance means reducing your tax deduction by the same percentage. Think of it as the reverse of a tax advantaged account. This says nothing about whether you should prepay mortgage debt.

The Limits of Tax Efficient Investing Space

So lets explore how much we can really get into tax advantaged accounts if we are industrious. Well there is the obvious 18K in a regular 401K. Add to that up to 53K into a solo 401K depending on how much profit your business makes at 20%. Execute a Roth IRA conversion or contribution at $5,500. Contribute after tax to an employer 401K up to the 54K limit to add 36K to your Roth. Obviously take the $3,400 dollars and put it into an HSA. Meanwhile, utilize $2,500 for your dependent care FSA. Double everything except the HSA if your married. Take the HSA to $6,750 if your married.

The result:
Pre tax: 18K+ up to 53K + employer match= up to $71K/yr per person.
Post Tax: $5.5K+36K= up to $41.5K/yr/person
Both: 3.4K + 2.5K= $5.9K/yr/person

Potential Total Per Person in a near Perfect Scenario: 118.4K/yr per person

That’s a Huge Amount of Tax Efficient Investing Space

If you can fill up all that tax advantaged space you are doing better than we are. The possibilities are quite large. If you happen to work at an organization with a 457 Plan the numbers become even larger or perhaps replace some of the need for a successful business. In any case you can see that the key is controlling your sources of income. The more sources the more space you can potentially utilize.

Did I miss any accounts? Any disagreements with my tax efficiency ranking?  Do you, like me, tend to seek out Tax Efficient Investing Opportunities?

7 Comments

  1. SomeRandomGuyOnline
    SomeRandomGuyOnline October 16, 2017

    Nice breakdown, FTF. I pretty much agree with your rankings, although I would probably put the traditional IRA one or two rungs higher. There are deduction phaseouts if you are covered by a workplace retirement plan. However, you get the full deduction if you are not (and if your spouse is not covered as well). So for those without access to a 401k or similar, a tIRA would be the only way (outside of an HSA) to save for retirement on a pretax basis and lower their AGI. Splitting hairs, though.

    • FullTimeFinance
      FullTimeFinance October 16, 2017

      Good point, I’d failed to consider those without a 401k or 457k. In that case you are right a tIRA would move up a spot or two.

  2. Mr. Need2Save
    Mr. Need2Save October 16, 2017

    Very nice roundup. Of all the options on your list, we just contribute to HSA, 401(k), and ESPP. For the ESPP, I sell the stock immediately, so no tax savings there.

    I need to investigate more, but I’m not sure if the Backdoor Roth and 401K Taxable contribution to a Roth Conversion (if my company/plan permits it) are worth the effort. We have pretty large balances in our Traditional IRAs (from 401k rollovers), so I think that complicates matters.

    • FullTimeFinance
      FullTimeFinance October 17, 2017

      I’d definitely suggest you look at it. The cost of the Roth conversion is you lock the money up for 5 years. Even if you only leave it in there for those 5 years, 5 years of not paying taxes on earnings can add up quick depending on the behavior of the market.

  3. Actuaryonfire
    Actuaryonfire October 17, 2017

    Wonderful summary! Nice and crisp with all the detail. Most of it I knew, but putting it in one place has value to me. Thanks

  4. Torch Red
    Torch Red October 24, 2017

    This is the first time I have come across such a comprehensive and ranked list. Thanks for doing this.

    The argument you make for ranking Roth 401K so low is compelling… Anything one puts into Roth 401K, lowers the cap on traditional 401K. With after-tax conversions to Roth and back door Roth, one can get Roth tax space in other ways that don’t limit pre-tax tax space.

    • FullTimeFinance
      FullTimeFinance October 24, 2017

      Thanks Torch Red, hopefully people fine it useful.

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