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U.S. tax laws are complex. Spending my time and energy thinking about complicated tax schemes ranks right up there with having dental work done. . . without novocaine.

However, mistakes I made early in my career made me realize that totally ignoring tax planning is an expensive mistake. Taxes are a major detriment to building wealth. Tax planning is a necessity for those looking to quickly build wealth to enable early retirement.

It’s easy to be overwhelmed by stories like this one, reporting that the tax code has doubled since 1955 and is approximately 6,550 pages long. Fortunately, tax planning doesn’t need to be complicated.

Each of us needs to find the portions of the tax code that apply to our individual situation. We can then learn to control the things we can control while ignoring the vast majority of the law which doesn’t apply to us.

One of the easiest and most effective things you can do when saving and investing for retirement is to use tax advantaged accounts. It’s important to develop a framework for how to use these accounts to build up and then spend down wealth in the most tax efficient way possible.

Understanding Your Options

Anyone with earned income that does not exceed the limits allowed by the law can utilize a tax deductible individual retirement account (IRA) or contribute after tax dollars to a Roth IRA where future earnings and distributions are tax free.

Many employees have access to work sponsored retirement accounts. These may include 401(k), 403(b), Thrift Savings Plan, or Simple IRA depending on your employer. The self employed may set up Solo 401(k) or SEP IRAs. A recent CNBC report states that “seven in 10 companies offer a Roth 401(k) option,” giving further opportunity for those with work sponsored retirement accounts to decide between tax-deferred and Roth options.

Those with high deductible health insurance plans can utilize health savings accounts (HSA). Parents concurrently saving for retirement and their children’s education have other options for tax advantaged saving, including 529 plans.

Taxable accounts can play an important role in retirement saving. They can be surprisingly tax efficient for retirees. They also are simpler than tax advantaged accounts if you need to access funds prior to traditional retirement age.

With all of the options, where do you start and how do you avoid getting stuck in paralysis by analysis? We need rules to guide us.

Establishing an Order of Operations

Having all these investing options presents two challenges. The first is to figure out which accounts you have access to. Next, you must prioritize the order for funding them in the most tax and cost efficient way.

When my wife and I were saving aggressively for early retirement, our decisions were easy because we needed to save aggressively to meet our goals. So we maxed out contributions to all the tax advantaged retirement accounts available to us and then saved additionally in taxable accounts.

We first maxed out our 401(k) accounts. This lowered our adjusted gross income enough to fully contribute to Roth IRA accounts, but not enough to contribute to deductible IRAs. This essentially made the decision for us to fully fund Roth IRA accounts. Anything left over went to taxable investments.

We didn’t see much value in 529 college accounts for our situation. We never had access to HSA or self-employed retirement accounts, eliminating those decisions. Contributions were placed on autopilot, and we never considered these decisions again.

Now we’re in semi-retirement with only my wife’s part-time income and my small income from writing. We need to establish a new framework for saving in and taking from these accounts.

Similarly, many saving for retirement who have lower incomes or higher expenses than we had will be faced with harder decisions about whether to invest in tax-deferred, taxable or Roth vehicles, what specific accounts to use, and in what order to prioritize funding them.

It is helpful to have a framework and an order of operations to guide your planning. This prevents the need to re-evaluate this decision from scratch every year, or worse yet have no plan.

Seeing the Big Picture

Using tax advantaged investment accounts gives you the option to use timing strategies to decrease the total amount of tax you pay over your lifetime.

Using tax deferred investment accounts during high earning (and thus high tax) years allows you to avoid paying at upper marginal tax rates in the year money is earned. Early retirees with a low cost of living can spread this income over many years in which the taxes are paid at lower effective tax rates when you are not earning a high income.

Likewise, tax-loss harvesting is a way to avoid paying capital gains taxes on taxable investments in your high earning working years. In retirement, or in lower earning semi-retirement years, capital gains can be paid at lower rates when money is taken from the accounts. Long-term capital gains are taxed at a rate of 0% at the federal level for those in the 10 and 12% marginal tax brackets.

Some may use strategies like Roth IRA conversions and tax gain harvesting to create taxable events in lower earning years. In contrast to tax deferral strategies, these strategies accelerate the timing that taxes are paid to take advantage of the opportunity to pay them at lower rates in years when income is low.

We also need to balance the fees, limited investment options, and rules and regulations that come with the different tax advantaged account types.

Against this backdrop, how do you determine whether to utilize tax-deferred, taxable or Roth options? And in what order should we prioritize funding these different accounts?

First Consideration: Getting ACA Subsidies

My wife and I have always gotten our insurance through employers. We decided to have one of us continue working enough to continue receiving this benefit while we gradually transition into a more traditional retirement.

When the time comes that neither of us have employer provided health insurance, this will become the most important factor in determining our tax strategy. Optimizing ACA subsidies provides immediate and potentially large financial benefits.

As I reported last November after researching our health insurance options, the price we could pay for the exact same insurance plan for our family could range from a low of $982 per year to as much as $16,817. The wide variability is because ACA premium subsidies are based on your taxable income, technically your Modified Adjusted Gross Income (MAGI).

We would be especially wary if approaching the “subsidy cliff” where having too high of a MAGI would cause us to lose all subsidies. In our scenario, going one dollar over the cliff could cost us $8,194 in lost subsidies for the year.

Therefore, it behooves an early retiree, semi-retiree or entrepreneur needing to purchase insurance on the open marketplace to do whatever is possible to first control taxable income. You can accomplish this by using tax-deferred investment accounts to optimize ACA subsidies and try to limit your out of pocket insurance premium costs.

Second Consideration: Finding “Too Good to Pass Up” Options

There are a number of factors that go into deciding whether to use tax advantaged savings accounts and in what order to fund them. At the top of the list for my wife and I are financial simplicity.

There needs to be a compelling reason to add the complexity of utilizing a tax advantaged account or making additional financial transactions in the face of uncertain benefits. It is easier to use our earned income to provide cash flow and add to or take from taxable investments as needed.

This decision will be different for each of us. Here are two options for tax advantaged investing that I feel are too good for nearly anyone to pass up if they are available.

Getting an Employer Match

The first option is to receive an employer match for your contributions to work sponsored accounts. My wife’s employer matches her 401(k) contributions 100% on the first 3% and then 50% on the next 2% of her salary. They do not provide any incentive or match for HSA contributions.

In 2018, we were still in the accumulation mode mindset to max out all available retirement accounts, so my wife maxed out her 401(k). Contributing so much to her 401(k) caused us headaches when we tried to create enough cash flow to meet our monthly spending needs.

In exchange for the inconvenience, we got what is likely to be a marginal, at best, long-term tax benefit. Worse yet, this locked us into subpar investment options available through her plan. In a review of our investment portfolio last year, we found that her 401(k) made up only 4.3% of our portfolio, but accounted for 38% of our investment fees!

Going forward, she will contribute only to the level of the employer match. This essentially provides an 80% instant risk-free return on her contribution. That translates into a few thousand dollars of free money. The contribution also provides a small tax deduction.

Paying off high interest debt or having a high probability of not vesting and losing this free money are the only reasons not to contribute to an employer sponsored plan up to the employer match.

Beyond the level of the match, we will bypass contributing more to work sponsored retirement plans. The reward is not great enough for us to shift money around to manage our cash flow and deal with excessive investment fees.

Utilizing an HSA

The second factor is whether you have access to an HSA. My original research into HSAs left me lukewarm on them. Reader comments on that post, discovering some excellent options to invest an HSA, and subsequent developments in the HSA marketplace that further improved those options changed my opinion and left me feeling more bullish about them.

Here is my rationale. Contributing to an HSA provides a deduction at your marginal rate. Even if you are in a relatively low marginal tax bracket of 10 or 12%, this deduction will save several hundred dollars in the year of the contribution.

I’m quite sure  we’ll need to cover the cost of health expenses for someone in our family over the next 20-30 years. In that case we get a triple tax benefit; tax deductible contribution, tax-free growth until withdrawal and tax-free withdrawal.

In a “worst case” scenario, this is a great bet to “lose.” It means we all stayed healthy, and the HSA then acts like a traditional IRA which is taxed at ordinary income tax rates. For us, it is unlikely we’ll pay more than 10-12% effective tax rate, so taxes would be a wash.

Unlike 401(k) plans, HSA investment options are not limited by your employer’s choice of provider. You can choose companies like Lively or Fidelity (we have no affiliate relationship with either) to invest your HSA without management fees.

We decided the benefits of funding an HSA are great enough that we will fully fund one every year it is available to us. We will do this even when it requires some effort to sell off taxable investments (assuming we pay no long-term capital gains taxes in the process) to fund it.

Third Consideration: Defining High and Low Tax Rates

Tax strategies require you to take definitive action in the face of an unknown future. I use terms high and low tax rates, but they are relative and speculative.

We each need to quantify the terms high and low marginal tax rates for the purpose of tax planning. When both of us were working, our household income typically put us firmly in the 25% (now 22%) federal marginal tax brackets. I consider these rates or anything above them to be high, leading us to first utilize tax-deferred investment options. Here is some perspective.

It was helpful for me to read Darrow’s posts on this blog over the years. He reported his effective federal income tax rate in 2014, 2016 and 2018 in early retirement. His average federal effective tax rate consistently had been less than 5%.

However, he is still in the early retirement stage, not yet eligible for social security or subject to required minimum distributions (RMD). Those factors reduce your ability to control your tax rate.

With many years to spread out taxes at low effective rates and with good planning, it is hard for me to imagine paying an effective rate greater than 10-12% in any given year of retirement. So we took advantage of every opportunity to defer taxes when in a “high” marginal rate.

Now that we’re transitioning to lower earning retirement years we will look for any opportunities to do Roth IRA conversions if there are years we could do so without paying taxes up to the standard deduction. More realistically for us at this point, we’re looking for opportunities for tax gain harvesting. In either case, these are no brainer decisions of accelerating taxes to “pay” them at a rate of 0%.

Decisions are less clear when deciding to defer taxes on income in the 10 and 12% marginal tax brackets or when having to actually pay taxes sooner than necessary. This is where it is helpful to have rules to guide your decisions.

No one would disagree that 0% is low. You may disagree with my definition of the 22 percent or above marginal tax rate as “high” and 10 and 12 percent as “crap shoots” based on the specifics of your circumstances. Wherever you choose to draw the line, it is helpful to have rules in place to determine whether to emphasize deferring taxes, accelerating them, or having a laissez-faire approach.

Fourth Consideration: Tax Rate Diversification

Next we consider diversification amongst tax-deferred, taxable and Roth accounts. The only thing we know about the future with certainty is that we don’t know anything about the future with certainty.

I therefore want diversification not only among asset classes but also tax diversification among  account types. We calculate this in a spreadsheet where we track our investment portfolio.

Our portfolio is evenly split between tax-deferred and taxable accounts, each making up approximately 45% of the value. Our Roth accounts are about 10% of our portfolio with our HSA account comprising less than 1% of our portfolio.

There is no optimal percentage to have in each account. However, the absolute value of your tax-deferred accounts, the number of years until you are subject to RMDs, whether you receive a pension, the size of your social security benefit and when you take it, and having some flexibility in how you take money from your accounts all contribute to how much tax you pay on that money over your lifetime.

Diversification was a secondary consideration when we had a higher income, with tax-deferral taking precedence. Now that it is less clear whether a tax-deferred, taxable, or Roth option is optimal for us, diversification is a bigger factor.

Our current strategy is to turn off the option to automatically reinvest dividends on our taxable accounts. We can use this money to supplement cash flow if needed. If not needed, it will be used to fund our HSA and then Roth IRAs each year. If more is needed to fund these accounts fully, we will sell off taxable investments as long as it doesn’t trigger capital gains taxes.

Developing Your Own Order of Operations

As with all personal finance topics, determine your priorities and make decisions to fit your personal situation. I’m sharing our decision process not as a one-size-fits-all solution, but as a template to evaluate your own decisions. We each need to develop our own framework to systematize and simplify our finances.

Taking the time now to develop a comprehensive plan and framework for decision making can save you substantial time and money over the long term. No one enjoys thinking about taxes, but there are few things you can do to save more money with less sacrifice than developing a simple, sensible and legal tax avoidance plan now.

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Valuable Resources

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