PSA: Use Your Tax-Advantaged Accounts
Updated: Jan 17, 2020
Not all money-saving methods are equal. Think stashing your money under a mattress in cash, where its buying power shrinks each year due to inflation, versus investing in the market for a compounding 7% growth a year.
If you're reading a finance blog, you're probably savvy enough to be investing over keeping cash. So how can we do better on our investments? By either 1) Raising Return, or 2) Cutting Costs.
1) Raising Return:
I'm not going to spend much time on this because I invest in Passively Managed Index Funds. I'm fine getting average returns because it's just about impossible to mess up. And Warren Buffet agrees. If you want a good example, look at VTSAX.
2) Cutting Costs
Since we're using passively-managed funds, our Expense Ratios should be nice and low.
So, the next most important point (and the title of this post) is minimizing taxes.
Since the government gives us tax breaks for saving, we should definitely use them. Here are the three main accounts I use to save over $5000 a year in taxes:
This is the big one for two reasons. First, it has the highest limit at $19,500 in 2020, and all of that saves you in taxes. In general, you can choose between saving on taxes up front (traditional) or when you withdraw (Roth). What you choose is personal preference, but I'm going with traditional. Second, most employers give you a company match on 401(k) contributions, which is probably the best return on investment you can get. My company gives me 6% if I put in 8%, meaning that I've instantly made a 175% return on investment... before the money even gets invested! If you can't do anything else, get your 401(k) match.
Although your 401(k) is through your employer, everyone is eligible for an IRA. You can open one through any investment company like TD Ameritrade or Vanguard. The limit for this account is much smaller at $6000 for 2020, but that's still a good chunk. An important difference between the 401(k) and IRA is that there is a tax deduction limit for the IRA. Because I can't get a full deduction, I use the Roth version of my IRA.
This last account is only available if you have a High-Deductible Health Insurance Plan. This account is intended for medical expenses, which is why you need a valid medical receipt to withdraw funds without a penalty (before the proper age). However, most HSA accounts let you invest your balance just like a normal brokerage account! The financially savvy move is to fully fund your HSA ($3500 in 2020) and then invest it all. MadFientist has a great article about why he thinks the HSA is the superhero of retirement accounts.
Adding it all up
The total benefit of maxing all these accounts might surprise you. For simplicity I'll assume the IRA contribution is traditional, and the investor is eligible for a full tax deduction:
$19,500 (401k) + $6000 (IRA) + $3500 (HSA) = $29,000
To find out how much you save on taxes, multiply that contribution total by your marginal tax rate - we'll use 22% as our example.
$29,000 (tax-advantaged contribution) * .22 (tax rate) = $6380 in tax savings
And that doesn't include the 401(k) match, which could get you a few thousand more in "Free Money"!
Boom. By investing money in these tax-advantaged accounts instead of a normal brokerage account, you're freeing up over $6000 to help make ends meet or continue investing.
If you keep making optimizations like this, you'll be able to reach financial independence much faster.