Posts Tagged ‘401(k)’

Investing in a Retirement Account is Like Taking Out a Loan

Traditional retirement plan contributions come with a loan attached to it with a variable rate of interest, to be determined at a later date by the tax code and your income level. #interestrate #interest #loan #IRS #taxesEver since the FIRE (financial independence/early retirement) movement hit the scene I started to question conventional financial wisdom. 

Most of the advice preached was re-purposed from generations past. A penny saved is a penny earned turned into a variety of frugal anecdotes. You can’t read Proverbs (from the Bible) and not recognize the many similarities in advice. Sound money principles have ancient roots.

For a time the FIRE community welcomed me as one of their own before I stepped back a bit to cut my own path. (No sense in another voice calling out the same message.) I’m still part of the community, but gave myself permission to question the dictums of said community. The hope was to build a bridge from where we are to a higher level.

It also became clear my net worth was near the top of the demographic. This bothered me and caused me to conclude something was wrong.  How could a backwoods farm boy with nothing more than a high school education, a few college courses and a full personal library do better than virtually all within a community so dedicated to wealth?

I don’t trust luck to carry me that far. It had to be something else.

Then I started reading what was published in the tax field and felt a great disturbance in the force. While the advice was fundamentally sound, it also lacked in effectiveness if brought to task. All too often blogs were using IRS publications as their authority. (The IRS is NOT a tax authority; they are a bill collector.) If people followed this advice and the IRS ever challenged (likely with so many people tempting fate) there was a real risk of loss. (If you go to Tax Court and say you used an IRS publication as your substantial authority you lose automatically even of you a right! IRS publications have zero authority in Tax Court.)

Sometimes the math was fuzzy. A blogger might claim a certain level of frugality when it didn’t add up. Some claimed a level of wealth that also didn’t add up. Either the rules of mathematics were suspended or someone was trying to pull the wool over their reader’s eyes.

The biggest area of concern involved retirement accounts. The mantra of filling retirement accounts to the hilt for long periods of time has some obvious issues

Some retirement account problems are less apparent. Everyone keeps saying this is the best thing since sliced bread. But is it? 

So I started running some numbers and it wasn’t as clear as most are led to believe. There was something fundamentally wrong with the advice.

 

Numbers Game

The issue is with traditional retirement accounts (IRA, 401(k), 457, 403(b), Keogh, profit-sharing and cash balance plans); Roth type retirement plans don’t have this issue.

Don't lose your retirement account to hidden taxes. Current tax savings are dwarfed by future taxes on all the gains at the highest rate allowed by law. It's your money! Don't give it to the IRS. #retirement #account #hidden #taxesRoth style retirement plans don’t get an up-front deduction, but grow tax-free. Most financial blogs consider this the best animal in the yard. I agree.

A close cousin — if you qualify for it — is the health savings account where you get a deduction and tax-free growth, to be used for qualified medical expenses. The biggest drawback of the HSA is the amount you can invest annually is relatively small. 

Roth retirement plans are limited in many cases based on income on if the employer has the option in their 401(k) . The maximum Roth IRA contribution is also relatively small. (Exact limits are excluded from this post so changes in the limit don’t distract from the evergreen content.)

The mega-backdoor Roth (a favorite of the FIRE community) allows for sizable Roth contributions with one caveat: it’s probably illegal (according to the IRS). The IRS hasn’t attacked the mega-backdoor Roth because there is no current revenue to be raised by taking such action; Roth investments are not deductible.

However, once these accounts grow in size the IRS could come back and disallow the tax-free advantage, plus interest and penalties. If the IRS has a kind heart (ahem) they could forgo the excess contribution issues which would certainly mean penalties several hundred percent of the entire investment. You decide what course you wish to take. 

The safest retirement plan route means traditional retirement plan investments after you maximized your Roth contributions. Or is it?

 

Loan Document

Traditional retirement plan contributions come with a loan attached to it with a variable rate of interest, to be determined at a later date by the tax code and your income level.

All you debt-free warriors should feel a bit nervous at this point. Just as a mortgage-free home still has loan-like obligations (property taxes, insurance, maintenance), a traditional retirement account has an unannounced interest-like expense and it is a big one.

And this is what disturbed me so much that I had to publish a post on it. 

We all know that traditional retirement accounts get a tax deduction at your ordinary tax rate up to the retirement plan contribution limits. We should also know that these accounts grow tax-deferred and that all distributions are taxed at ordinary rates.

This is a real problem if your goal is to maximize your net worth. In the early years the tax benefit makes it seem like it is the best deal on the planet. But as time passes the math tells a darker tale.

Let’s start with a simple example to get a fundamental understanding of this matter:

Joe contributes $10,000 to his t401(k). This is subtracted from his income on the W-2 and never reaches his tax return. His tax bracket is 30%.

We will disregard actual tax brackets as they change over time and we are more interested in a workable formula for determining the best course currently and for future readers as well.

The good news is Joe saved $3,000 on his taxes this year. However, in 40 years, when Joe retires, he discovers his investment in a broad-based index fund performed as index funds have over long periods in the past: around 7% per year on average. Joe is a very happy man! He now has $149,744.58. 

If Joe were to take the entire amount in one year it would be a fairly large tax. However, Joe decides to take the money out over a number of years. As a result his ordinary tax rate is only 15%. (We will disregard taxes on Social Security benefits and other similar issues to make calculations easier.)

Joe now has a tax bill of $22,462. (Numbers are rounded.) That is $19,462 more in additional tax! Call the 19 grand a tax or anything else you want, but it looks like interest on the $3,000 to this accountant.

Even though Joe saw his tax rate decline by half in retirement he still saw his tax bill increase over 700%. His interest rate would be slightly less than 5.2% annualized in this situation assuming Joe never saw his account value increase after he started taking distributions, an unlikely event.

 

Early Payments

If I approached you and said I would borrow you $20,000 at 5.2% would you take it? Unless you have bad credit that is a high interest rate, especially since it in not deductible. Worse, you can’t make early payments to get out of the deal! You can’t jump ship until you are at least 59 1/2 years old. And if you are stubborn I’ll kick you overboard at 70 1/2. 

The good news is I’m a nice guy and will not do that to you. On the other hand, Congress has passed laws the IRS carries out doing just that.

And we haven’t seen the worst part yet! Retirement plan distribution included in income can cause more of your Social Security benefits to be taxed and can also increase the premium you pay for Medicare once you reach age 65.

A small tax deduction today can do real damage in the future. This is why I say I want multiple tax benefits before I get excited about a tax deduction

All this assumes your tax bracket drops when you retire. Considering the massive government fiscal deficits during a strong economy, it seems to this accountant taxes will go up in the future. And if your income remains high in retirement your tax bracket will also be higher.

Consider this: If Joe had a 30% ordinary tax rate on his retirement plan distributions his taxes would have climbed to $44,923, a full 7% annualized rate. For people with good credit this is a massive interest rate and almost nobody is thinking about this.

 

The Cold Equations

Joe’s example is unfair. First, Joe will put a lot more into his retirement plan over his lifetime, therefore, the damage will be much larger.

Second, retirement plan distributions happen over a number of years. While this might sound like a solution to the problem, it actually makes it worse as the investments continue to grow over time.

Third, smaller account balances experience the same issue only with smaller numbers and that tax rates might be lower due to the lower income level.

Fourth, early retirement does not solve the problem. Yes, you can take a limited amount of money from a traditional retirement account before age 59 1/2 without penalty under Section 72(t). This only reduces the amount of time the money has to grow; it doesn’t resolve the issue.

No matter how you cut it, traditional retirement accounts are best viewed as loans from the government, due in retirement. If you don’t pay the piper, your beneficiaries will.

 

 

Alternatives

Your experience will differ from that of others. You can use the simple example above to determine your implied interest rate assessed as tax in the future. You may discover this isn’t an issue for you. Or, you might need a moment for reflective prayer.

We saw that greed for a current tax deduction produces a 5%+ interest rate loan from the government, payable in retirement. So, what alternatives are there?

The best comparison is doing nothing at all (investing in a non-qualified account). You still invest in the same index fund. Dividends and capital gains are taxed at the lower long-term capital gains (LTCG) tax rate (15% or less for most taxpayers) instead of ordinary rates later (up to 37% federal, plus state income taxes). 

Since the money is outside a traditional retirement account you don’t have to worry about early distributions or required minimum distributions. And if you die your beneficiaries get a step-up in basis the retirement accounts don’t get. Gains on these investments are also taxed at the lower LTCG rate. 

 

Matching

I can hear the complaint already: What if my employer matches?

A valid argument. We’ll go back to Joe again and assume his employer matched his contribution 100%.

Joe invested $10,000 of his own money and his employer matched his retirement plan contribution with another $10,000. 

Joe still gets a deduction worth $3,000 for his contribution. The employer’s match is free money and not taxed until Joe takes the money out.

In total, Joe has $20,000 invested in his retirement account. His account grows to $299,489 in 40 years. The tax on this at a 15% tax rate is: $44,923. 

The initial tax benefit to Joe is $3,000, plus $10,000 from his employer, for a total of $13,000. The implied interest rate in this situation is around 3.15%.

The lesson of this part of the story is that using your employer’s retirement plan up to the match maximum is still a good idea for most. After hitting the matching maximum you might be better served putting the rest into a non-qualified account, however.

 

Smart readers will also be quick to point out the extra tax savings means you have more to invest which mitigates any of the extra taxes owed in the future. This would be true if people actually did that.

When was the last time you invested your tax savings from a traditional retirement account investment? Where did you invest it? Uh-huh. Thought so. You spend the tax savings as most do.

(If you are one of the few who actually pull the tax savings from the family budget and invest it in a non-qualified account my hat comes off to you. You still need to run the numbers to verify the best course of action.)

 

Facts and Circumstances

You can’t read tax law for more than a few minutes before running across the words “facts and circumstances”. And this situation is no different.

The IRS has hidden interest-like charges on retirement accounts. Here is how to avoid them. #avoidtaxes #taxes #retirement #IRS #interestI gave you the tools to build a working plan based on your facts and circumstances. Use a future value calculator to determine the interest rate the tax code is forcing you to pay if you use traditional retirement accounts. 

Employer matching is a real benefit that is diminished by the tax code after very long periods of time. (I would focus on the employer match closely as real value can be found there.)

After the employer match and available Roth retirement plan contributions allowed are exhausted you might find non-qualified accounts the best course of action, for you

The important thing is that you are reading this. That means you are more likely to run your numbers for the best options, for you

There are a lot of factors at play. Index funds still kick out dividends and some capital gains which are currently taxed. This slightly reduced the implied interest rate of the traditional retirement plan if you are prone to investing tax savings. It also assumes you keep your fingers off the pile until retirement. 

The one thing to remember is that deferred taxes frequently come with an implied interest rate paid as a higher future tax.

This is the kind of stuff I think about in the dark of the night. It might also be the prime reason I top the net worth list at Rockstar Finance.

 

 

More Wealth Building Resources

Credit Cards can be a powerful money management tool when used correctly. Use this link to find a listing of the best credit card offers. You can expand your search to maximize cash and travel rewards.

Personal Capital is an incredible tool to manage all your investments in one place. You can watch your net worth grow as you reach toward financial independence and beyond. Did I mention Personal Capital is free?

Side Hustle Selling tradelines yields a high return compared to time invested, as much as $1,000 per hour. The tradeline company I use is Tradeline Supply Company. Let Darren know you are from The Wealthy Accountant. Call 888-844-8910, email Darren@TradelineSupply.com or read my review.

Medi-Share is a low cost way to manage health care costs. As health insurance premiums continue to sky rocket, there is an alternative preserving the wealth of families all over America. Here is my review of Medi-Share and additional resources to bring health care under control in your household.

QuickBooks is a daily part of life in my office. Managing a business requires accurate books without wasting time. QuickBooks is an excellent tool for managing your business, rental properties, side hustle and personal finances.

cost segregation study can reduce taxes $100,000 for income property owners. Here is my review of how cost segregation studies work and how to get one yourself.

Worthy Financial offers a flat 5% on their investment. You can read my review here. 

Maximizing Retirement Investments with Multiple Plans

Every so often I say something that starts a firestorm or causes my inbox to overflow. Since the laws of nature state I am one human being and have a limited amount of time to read and answer emails, most emails go unanswered unless from a current client.

It may have been something I said in a podcast or new readers enjoying a deep drink of my lovely prose triggering the question in question. (Yes, I wrote that intentionally.) The latest question storm revolves around retirement plans. The questions are all the same with slight nuances. As a human being with limited time to dedicate to cold call questions, I left most unanswered and the few I did respond to were given quick and to the point answers. And as I fired off these quick answers it occurred to me I misinterpreted the question asked in some cases. A fresh blog post on the subject should clear that up. If not, some ointment might also do the job.

The question stuffing my email is this: Can I have more than one retirement account? My accountant told me I can’t contribute to an IRA if I have a retirement plan at work. Is she right? We will address this line of questioning in a bit. There is a small twist to the question from some readers. Can I have two retirement plans in my business or side gig? I sent many a quick answer as follows: In most cases there is nothing in the Code disallowing such action, but it would be impractical to do so. My answer is wrong! I should have left questions unanswered if I didn’t have time for an adequate response.

The Skinny on Retirement Plans in Your Business

My answer wasn’t completely wrong, just wrong in many cases when you include the facts and circumstances of the questioner’s situation.

A small business can have two retirement plans, just not at the same time! Your side gig may have a solo 401(k), what Fidelity calls a Self Employed 401(k). The side gig may take on a life of its own and employees enter the scene. The solo 401(k) is no longer allowed. You have many options. For example, you might replace the solo 401(k) with a traditional 401(k) or a Simple 401(k) or a SIMPLE IRA. We will leave the characteristics of each retirement plan for another day. Today we will focus on when you can have more than one retirement plan at a time.

What is NOT allowed is a SIMPLE IRA plan and a 401(k) at the same time. Other restrictions exist. For example, a SIMPLE IRA cannot be shut down during the year. You must inform employees the SIMPLE plan will terminate at the end of the year before November 2nd of the current year.

Each retirement plan has its own limitations. The real question I am getting in emails is: Can I stack retirement plans to increase my retirement plan contributions? The answer is yes in most cases, but not within your business.

If you have two employers you can participate in both employers’ retirement plan as long as you don’t exceed the contribution limits. The 401(k) annual contribution limit is $18,000 per year with an additional $6,000 per year allowed for taxpayers age 50 or older.

Another limit facing all taxpayers in the ultimate retirement plan contribution limits of $54,000 annually, $60,000 for taxpayers age 50 and older. This $54,000/$60,000 limit includes the employer’s match! If you plan on maximizing your retirement plan contributions you need to track the employer match as well to avoid exceeding the limit.

If you have a 401(k) at your job you are allowed a solo 401(k) in your side gig or a SIMPLE IRA or other retirement plan that fits your needs as long as contribution limits are not exceeded. There are some limitations if you have ownership in your employer.

Some government employees have a 457 plan. The 457 contributions are not considered salary deferrals so you can load up the 457 plan while simultaneously filling a 403(b) or 401(k) in a side business or separate employer. The $18,000 ($24,000 age 50 and older) applies to the 457 plan and a 401(k)/403(b) plan at a separate employer. In effect, you can drop $18,000 into each retirement account.

The 457(b) plan also has a unique feature for taxpayers age 50 and over and within three years of retirement. Readers in this situation can reader more about the catch-up features of their retirement plan here.

Personal Retirement Plans

The questions that perplexed me the most claimed their accountant said they can’t contribute to an IRA if they have a retirement plan at work. It did not make sense to me at first. Unless limited by the $54,000/$60,000 limit, you can contribute to an IRA even if you have a retirement plan at work. What I think happened was readers misinterpreted what their tax professional said. IRA contributions are allowed, but may not be deductible.

Traditional and Roth IRA contributions allowed begin to phase out as your income increases until no contribution is allowed. However, a spousal IRA may be allowed if only one spouse has employment.

Too Many Choices

I included multiple links in this post rather than muddy this discussion with too many sidebars on separate types of retirement plan rules. The real problem is the number of choices. The reason so many ask about their retirement plan options is because the choices are endless. There are a limited number of plans, but the way the plans can be used produces a mind-boggling amount of choices and restrictions. My office is filled with books on this stuff. The answer is not always as simple as we would like it to be. (If you want to get serious about how retirement plans work, here is one book to start with.)

I think it is a mistake to answer these kinds of questions in a quick fashion as a favor to the reader. A quick, short answer means I didn’t crack open the books and verify what was being asked. This means I probably gave a half answer or worse, an incorrect one.

If I don’t answer an email question, do not be offended. I am not a free tax service so when I answer a quick question it is out of weakness. As this blog grows that weakness is getting crushed and that is a good thing.

There is a better chance I will respond to a comment. Answering the same email 68 times is a poor use of time when I can answer it once for all to benefit from.

It is with heavy heart I must inform you I will no longer answer personal tax questions unless you engage my services. I accept a small number of new clients per year. If you are looking for consulting I have more time available for that. Tax season is already stuffed to the rafters. There is a fee for my time. Rather than try to answer a bunch of questions halfway, I will serve paying clients with a complete answer. Many times I need to do research. I know a lot, but not everything. I open the book often.

Some things to consider: If you want to hire me I require a detailed outline of your questions in advance, plus a copy of your two most current tax returns. I disclose my fee when I offer engagement. It changes from time to time so I stopped publishing my regular fees. Be aware I am not cheap. It’s just a matter of economics. Too many people want me so fees are part of the filtering process.

Consulting conversations are on Wednesday only. I research and run my practice the rest of the week. I dedicate Wednesday to the phone or in person consultations. Be aware I am always scheduled out two months or more for consultations. If you need something this afternoon there is no way I can fit it in.

I love my work and want to serve as many people as possible. To do that I must firm-up my processes. I send all emails to my office manager, Karen, after I give them a quick review. I love compliments, suggestions and concerns I may have said something wrong in a post. I read them all. Karen decides which clients we can take on before contacting them. I accept 3-5 new consulting jobs per week max while I receive over 80 requests per week and growing. Please understand my time constraints.

Finally, I want to let you in on a little secret about tax professionals. When a tax pro prepares a tax return they get paid for the service. Many of these pros feel obligated to answer questions and consult for free because they prepared the return. This is unfair to the tax pro and leads to poor consulting. Tax pros frequently require research. This takes time and time is money. I am not the only good tax guy out there. You become a priority when the work involved includes some income with it. Demand your tax pro invoice you for consulting and demand adequate research connected to the fee-based consulting. This will divert questions from me to highly qualified tax pros in your local community.

Hopefully I whet your appetite on maximizing your retirement contributions today. Use the links to further your education. Use the comments for tax questions and if time permits I will answer your question. You can also contact me if you wish to hire my services. The best news of all: I have no problem working with your accountant to carry out a tax strategy. Once your tax pro knows how to use a tax saving strategy they can spread the good news to all their clients. We need to grow this thing so all middle class Americans get the same high quality tax advice the wealthy do at a price they can afford.

Tax-Advantaged versus Regular Accounts

Nick H recently emailed me a question about how much money he should invest in tax-advantaged accounts before adding to non-qualified accounts. Due to the large number of emails I receive I am unable to provide individualized tax advice unless you are a client. Nick’s question had a familiar ring. Several times per week I get a variation of the same question. Rather than ignore the request, I decided to put it into a post so all readers can benefit from my suggestions.

Here is Nick’s complete email:

Dear Wealth Accountant,

I have been a reader of yours for a few months now, and enjoy it very much.  I was introduced to your site via a MMM post.

I have a question for you regarding investing in tax-advantaged accounts vs. normal accounts. Standard advice is that I should max out tax advantaged accounts before saving in normal accounts.  However, with financial independence/early retirement in mind, if I do not make enough to max out tax advantaged accounts and save enough in a normal account for early retirement, I think that it makes more sense to put just enough into a 401k to get my match, then save everything else I can in a normal investment account.

I reach this conclusion because the goal of early retirement is to build up an income stream, unlike standard retirement in which you just achieve the largest possible pile of cash.  Since there are significant limitations on access to the funds in taxed advantaged accounts, this seems like an inefficient method of saving.  Again, assuming that I have to choose between the two.

Thanks
-Nick H

PS. I also posed this question to MMM.  I am very curious to get both of your perspectives on it.  Thanks & hope to hear from you!

Nick makes a narrow assumption of either/or. He indicates he either has to max out his retirement accounts before funding non-qualified accounts or he will not have an income stream to fund his early retirement.

Nick also turns the tables on the standard advice by saying standard advice says to max out retirement accounts. I guess it depends on whose standard advice we are looking at. Most standard advice is geared toward generating larger fees for the investment house. Standard advice says you should save 10% of your income. It makes me nauseous thinking about it.
Filling the Kettle

From the email it seems to me Nick wants me to justify his conclusions. I cannot. Investing in a work 401(k) up to the matching level only because it is hard to get the money out in early retirement is narrow thinking.

My opinion, and the opinion of most bloggers in the FIRE (financial independence, retire early) community, teaches you should invest as much as possible in tax-advantaged accounts before filling non-qualified accounts. My standard advice is to save half your gross income. Money invested in your 401(k) is tax deferred. Each dollar invested in a qualified account that is deductible reduces your taxes making it easier to save more.

If you are saving 50% of your gross income the 401(k) will not be your only saving/investing vehicle. You will probably use a Roth IRA in combination with your 401(k). The beauty of a Roth IRA is you can take your basis out at any age without affecting your taxes.

Early retirement requires distribution planning. Once you retire you will probably transfer your 401(k)/457 plan/403(b) or other retirement plan from work to a traditional IRA where you can take distributions under Section 72(t) or 72(q) if you have an annuity. There is a wide range of options available when beginning distributions from an IRA. The biggest issue involves how long you MUST keep taking distributions if you retire early. The rule is simple: once you start distributions under 72(t) you must continue until age 59 ½ or five years, whichever is longer. The distribution amount is generally fixed, but can go up in certain instances for inflation.

Distributions are calculated by one of three methods: Minimum Distributions Method, Amortization Method, or Annuitization Method. So we can stay focused on the topic at hand—how much should go into a retirement account before other accounts—we will avoid a lengthy discussion on the different methods. Each method does yield a different result. For example: a 40 year old with $750,000 in his IRA can take an annual distribution of $17,202 to as high as $27,729 assuming her spouse is the beneficiary, also 40 years old, with a hypothetical before-tax return on the investment of 6% and a distribution interest rate of 2.36%.

The $27,729 distribution brings us very close to the 4% rule rate of $30,000. But if you have been saving half your gross income, the 401(k) was not the only act in town. You should have some Roth IRA investments too. Maybe your income was too high so you used a backdoor Roth or made nondeductible traditional IRA contributions. A small side hustle would be more than enough with the 72(t) distribution to cover living expenses.

Even if 90% of your liquid investments were inside qualified accounts, you would still have non-qualified monies to meet additional expenses not covered by the 72(t) distribution. The higher distribution amount, $27,729, uses the amortization method of calculating the distribution amount. Under this method the distribution must remain unchanged. As time goes on the amount will be reduced by inflation. However, any Roth investments and non-qualified accounts can handle the small increase needed each year. And, since you will not retire with a remote in one hand and a beer in the other, you will certainly bring in token amounts of income just doing stuff you enjoy doing.

Problems with Regular Accounts

Non-qualified accounts have their own set of issues. If we follow Nick’s suggestion we will have a growing problem which will delay retirement. Money inside a retirement account grows tax deferred or even tax free. Index funds (the only thing we recommend around here) in a regular account will throw off ever increasing amounts of dividends and capital gains. Index funds generally are tax efficient, but as dividends grow each year, you will have a larger and larger tax burden to fund. Money paid in taxes reduces the funds available to invest, decreasing the size of your portfolio, hence, delaying early retirement plans.

Another issue with non-qualified accounts is that you will need a larger portfolio in retirement. Remember, once you retire, the index fund distributions are taxable whether you take them out or reinvest. Depending on your financial situation, this could increase your annual cash needs to fund retirement. If the dividend and capital gains distributions remain below your spending level the tax issue is moot. However, if you reinvest some of the index fund distribution you will have a higher tax bill than necessary, requiring more money to manage your annual financial needs.

Tax Loss Harvesting

There are ways to mitigate some of the tax issues surrounding investments with non qualified monies. Tax loss harvesting with programs from companies like Betterment should reduce taxes modestly early on. I like the idea of tax loss harvesting, but it is an imperfect solution to a problem. I recommend Betterment often enough and I am not an affiliate either.

GoCurryCracker! has a great article on why Betterment is not always the right answer. The maximum loss allowed after all other capital gains have been reduced is $3,000 per year. Yes, this deduction is against ordinary income and comes off your highest tax rate. Yes, when you later have a long-term capital gain it is taxed at LTCG rates which are lower.

There are serious considerations when using Betterment, as the GoCurryCracker! article makes clear. As much as I recommend tax loss harvesting, I also recommend tax gain harvesting! When your income is low it pays to realize LTCGs and pay the tax to get a higher basis. Many times your tax is zero on the gain when you plan accordingly!

The more money you have in regular accounts, the harder it is to manage the tax issues. Several million in non-qualified accounts will throw off significant amounts of taxable dividends and capital gains. Inside a qualified account you can keep deferring the money without tax consequences for a long time.

Roth IRAs have a delayed required distribution rules.* Traditional IRAs require a distribution once you reach 70 ½.

Investing Order

I have a list of the order you should invest your money. It starts with paying off debt and moves to investing in various accounts and assets. Your circumstances may require you to deviate slightly from my outline.

  1. Retirement plan at work up to the matching level.
  2. Debt reduction.
    1. High interest loans first
    2. Credit cards, payday loans
    3. Car loan
    4. Student loans
    5. Only pay required mortgage payment
  3. Non-qualified account for emergency needs (roof, car issues, medical, et cetera). Two months living expenses
  4. Health Savings Account (I might want to fill this first due to the significant tax advantages.)
  5. Max out retirement plan at work.
  6. Max out Roth IRA and any other qualified accounts outside work plan.
  7. Any additional fund go half to paying down mortgage faster and half to non-qualified accounts invested in index funds. Emergency fund no longer needed as you have ample funds to handle any emergency.
  8. Alternative investments
    1. Investment properties
      1. Residential rental real estate
      2. Commercial real estate
      3. Farmland
      4. Development
      5. Lending Club
      6. Other alternative investments.

The above list is similar to the way I handle my investment order. Since my only debt is my farm and the interest rate is under 2 ½%, I am in no rush to pay the mortgage off. I max out all retirement plans and the HSA before investing in non-qualified accounts. In reality, I invest in my non-qualified each month automatically. I do know all other qualified accounts will be fully funded.

I am not a big fan of emergency funds, but if you are starting out they can provide a buffer against financial setbacks. Alternative investments like Lending Club are passive is nature. Real estate is called passive for tax purposes, but requires more involvement in the investment than most other passive sources of income, even if you have a property manager.

And stay away from the crazy stuff. You can’t time the market any better than any other human to have ever lived. No day trading! Avoid commodities (unless you are hedging for your business or farm) and currencies. This includes Bitcoin.

I know, I know! Your uncle Fred made a killing in soybean futures and Bitcoin and you want in on some of that easy money. But remember, your uncle Fred is 78 and still can’t retire. Tells you something.

 

* Roth IRAs can delay required distributions for a long time. Under current law Roth IRAs do not require distribution until the death of the owner.