Optimizing your investments can add up to thousands of dollars
Figuring out how to best allocate your money among the many types of savings and investment vehicles can be confusing. This involves considering many areas of your financial life, such as your time horizon, investment goals, and your tax situation.
It also involves choosing from amongst different account types, such as retirement plans and accounts, taxable accounts, and health savings accounts. Each type of account has its own features, tax benefits, investment options, contribution limits, and withdrawal rules and fees.
For most people who have demanding schedules, this usually means they have little time to manage their finances. So how do you make sense of it all and prioritize your investment and savings account strategies?
Start With a Financial Plan
First and foremost, I advise clients to begin the process by establishing a solid financial plan.
This means starting by making a detailed budget that tracks where all your money is coming from and going each month. You’ll need to assess all your current expenses and discretionary spending. Also factor in periodic costs like insurance premiums, taxes, and other variable expenses.
The goal is to figure out what you really need to spend to live day-to-day, versus extra stuff you might be able to cut back on.
The Tax-Efficient Waterfall
The next step involves choosing which savings and investing accounts to prioritize and utilize. This is where the concept of a “tax-efficient waterfall” comes in.
This method involves allocating extra dollars sequentially to the most tax-advantaged accounts available, such as 401(k)s, IRAs, and health savings accounts, before taxable brokerage and savings accounts.
Instead of first focusing on individual investments, this method prioritizes where to put your money based on each type of account’s tax treatment. This method will maximize your returns through tax-efficient savings and investing, and minimize what you pay Uncle Sam.
Here is the order of the waterfall:
1. Contribute enough to employer-sponsored retirement plans for employer matches
First, fund employer-sponsored retirement plans, which allow you to either defer taxes on your contributions and earnings until retirement (traditional plans) or pay taxes upfront and enjoy tax-free withdrawals in retirement (Roth accounts).
Many employers will match contributions to your 401(k) or 403(b) plan up to a certain percentage of your salary. This is essentially free money that gives you an immediate return on your contribution.
You should contribute at least enough to take full advantage of the match. For example, if your employer matches 50% of your contributions up to 6% of your salary, you should contribute at least 6% (if not more) of your salary to your plan.
2. Pay off high-interest debt
Next, pay down high-interest debt. Carrying balances on high interest debt costs far more than your investment returns will earn. This is why the next step in the waterfall method is to eliminate any debt that has an interest rate higher than your expected investment return. This typically includes credit card debt, personal loans, car loans, and student loans.
You should focus on paying off the debt with the highest interest rate first, while making minimum payments on the rest. This is also known as the “debt avalanche” method.
The alternative is to use the “debt snowball” method, which involves paying off the smallest debt first and then moving on to the next one.
3. Max out contributions to other tax-advantaged accounts
The next step is to contribute to accounts such as HSAs, additional 401(k) contributions, and IRA accounts.
A Health Savings Account (HSA) is a unique account that offers triple tax benefits: you can deduct your contributions, your earnings are tax-free, and you can withdraw money for qualified medical expenses without paying taxes:
– HSA contributions can be made pre-tax through payroll deductions to lower your taxable income.
– Money in your HSA grows tax-deferred and can be invested in ETFs and funds, similar to an IRA. Withdrawals are also tax-free if used for qualified medical expenses.
– HSA funds roll over from year to year if not spent, and you own the account even if you change jobs or health plans.
– HSA contributions, earnings, and withdrawals for medical care are all exempt from taxes.
– Money saved in an HSA can grow over time, much more than money kept in savings accounts.
After maxing out your HSA, max out your 401(k), 403(b), or other company sponsored plans. The earnings grow tax-deferred in these accounts. Designated Roth accounts in 401(k) and 403(b) plans grow tax-free.
The next step is to contribute to an IRA. A traditional IRA gives you an upfront tax deduction, while a Roth IRA doesn’t provide a deduction, but provides tax-free withdrawals in retirement. Typically, a Roth IRA will provide greater tax savings over time compared to a traditional IRA.
4. Contribute to cash balance plans, non-qualified deferred compensation, solo 401(k)s, and mega backdoor Roth conversions
Now that the tax-advantaged retirement accounts are funded, explore other options available through your employer. Cash balance plans and non-qualified deferred compensation plans allow higher-income individuals to save more for retirement in a tax-efficient way.
If you’re self-employed, you can open a solo 401(k), which has much higher contribution limits than a traditional IRA. The upshot is that it enables you to put away much more for retirement each year on a pre-tax basis.
Lastly, determine if your employer offers a “mega backdoor Roth conversion” through their retirement plan. This allows making after-tax contributions that can then be converted to a Roth IRA, bypassing normal Roth IRA contribution limits.
5. Invest remaining funds in regular brokerage or savings accounts
The last step in the waterfall method is to invest any excess money that you have after funding all the previous accounts.
This money can be invested in taxable brokerage accounts or savings accounts. You’re able to choose from a huge range of investment options with these accounts, such as stocks, bonds, ETFs, REITs, or alternative investments. These accounts don’t offer any tax benefits, but they give you flexibility and control over your investments.
The main benefit is accessibility, as you’re able to access this money at any time without any penalties or restrictions, and it can be used easily for emergencies.
Final Thoughts
By using the waterfall method, you‘re able to ensure that you use all the tax benefits available before your funds are taxed at a higher rate later on.
The waterfall method has helped clients I work with simplify and optimize their tax and investment strategies and grow returns over time. By prioritizing and allocating funds in a systematic way, you can minimize the amount of money that goes to the government and instead put it to work for you. Over the long run, this can add up to tens of thousands of additional dollars.Are there other approaches to creating a long-term, tax-efficient investment plan?
Yes, but I’ve found the waterfall method to be a great starting point and the easiest to follow.
