September 2024
Here are some key takeaways from their conversation:
• Health Savings Accounts (HSAs) are highlighted for their “triple tax savings.” They offer tax deduction on contributions, tax-deferred growth, and tax-free withdrawals for qualified medical expenses. Many high earners avoid HSAs because of high deductibles, but Mike and Chris agree that generally, the tax benefits outweigh the cons for high earners.
•Traditional IRAs, 401(k)s, and Roth IRAs offer "double tax benefits." Traditional accounts provide tax deductions on contributions and tax-deferred growth, while Roth accounts offer tax-free growth and withdrawals after taxes are paid upfront. People who expect to be in a similar or higher tax bracket in retirement should contribute to a Roth. Sometimes, finding a balance between both can be an optimal tax strategy.
•Contribution to accounts should follow a hierarchy, prioritizing emergency funds, employer matches, and then high-interest debt repayment before moving on to other accounts.
•529 plans offer tax-free growth and tax-free withdrawals for qualified education expenses. This includes tuition for K-12 education and college, as well as expenses like books and supplies. They can also be used to pay off up to $10,000 in student loans per beneficiary, and the beneficiary can be changed to another family member.
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Ep. 102 A Financial Guide to Divorce: Tips from an Advisor
Ep. 101 Market Insights and the Election: What to Expect at Our Investor Symposium
Hello, everyone, and thank you for joining us for another episode of THE FINANCIAL COMMUTE. I'm your host, Chris Galeski, joined by Wealth Advisor and partner Mike Rudow. Thanks for joining us.
We were having a conversation around the different types of tax, the tax preference savings vehicles, whether it's health savings accounts, Roth IRAs, traditional IRAs, and the order of importance. And there's some misconceptions because people like to make an emotional decision when it comes to taxes. And there are some incredible tax benefits by some of these different accounts, but also some misconceptions. So we thought we'd have a conversation around the different types of vehicles. Kind of our thoughts on how you should the hierarchy of how you should prefer them, and then some common misunderstandings.
And it's so relevant because I think many of us have the opportunity to contribute to different accounts, but we don't know which ones we should be contributing to or in what order or how much. And so kind of just laying out the land, to give a, you know, high level understanding of, of each account and then, you know, giving in order of operation of how you should think of these things, of when you should be contributing to each after you know, what decisions you've already made to, to contribute.
Yeah. And so, like, if you're in the accumulation phase of life and you're saving for yourself now to build a larger nest egg for the future, there's certain accounts that you really want to take advantage of when you're young versus older. Whether you're a high-income earner versus not. And so trying to break it down and simplify it for everyone.
I think the one with the most amount of tax benefits, you kind of go through a triple, double, single kind of way to think about it. But the one that has triple stack tax savings is the health savings account. So let's talk a little bit about what you mean by triple tax saving. Yeah.
So in a health savings account you get a triple tax benefit and you get that unlike any other account. Right. So you get first on the contribution you get a tax deduction. So anything that you put into the health savings account, you get to take off of your your ordinary income for that year. Then you get tax deferred growth which is the second benefit second tax savings.
So any appreciation in the income that that's making, it's deferred taxes. And then on the distribution you could get tax free distributions just like a Roth as long as it's qualified expenses. So anything that has to do with, you know, long term care, any medical event, it's pretty expansive what an HSA will actually pay for.
Look, I love health savings accounts. Obviously, you can only get access to them if you're in a high deductible health plan. And a high deductible health plan isn't right for everybody. But if you're a really high income earner and you're making a lot of money, there are some real reasons why you'd want to choose a high deductible plan, save into the health savings account invested, and let that money accumulate and grow. So that way you have a tax free distribution account later on in retirement.
Yeah. And you're right, it's not necessarily for everybody. But if you are a high income earner there's the benefit outweighs any negative of having a higher deductible because there's no other account where you can get the same, you know, the triple tax benefit, and have the ability to contribute and allow that to grow. So treating it as truly, you know, part of retirement planning.
It's such a value add.
So before we go into sort of the hierarchy and how we think about somebody should be contributing to each one of these accounts, let's talk about the ones that have like a double tax benefit.
So for the double tax benefit you've got your traditional 401K or IRA. And then you've got your Roth. So in a traditional what you're going to do on, any contribution that you're making to account that's tax deductible. Right. So that's going to offset ordinary income. Then it grows tax deferred, which is the second benefit. But then on distribution you're going to pay taxes and you're going to pay ordinary income.
So based on whatever tax bracket you are when you make that distribution. Yeah. On the other side of it, the Roth is a double benefit also. You're actually going to pay the taxes before you, you contribute the money into the plan. But now taxes are paid, money grows, tax deferred. And then when you make the distribution, you're not paying any taxes.
You already paid the tax on those dollars and you're not paying any tax on the gains that, you attributed in that fund.
So and really, if you're contributing to a 401K that has a traditional or pretax option or a Roth option, you're really making a choice on where you think tax rates are today and where you think they might be for you in the future.
Right. You only win in a Roth, right if you're paying less taxes today than in the future.
The same or less, right?
And there's, there's other there's another like a 529 is also, a double tax benefit where you're contributing into the 529 with after-tax dollars. For the most part, some states will allow you to deduct state taxes.
Then it grows tax deferred. But then any qualified distributions that you have for educational expenses will be, nontaxable.
And so the reason why 529 has that benefit is because it's limited to higher education or secondary school. Right. And so they're offering you the benefit of getting that tax deferred growth and tax free withdrawal because you're putting after tax money in you lose some flexibility. Absolutely. But you're getting some benefit.
Yeah. You are I mean there's usually some sort of drawback to any of these. Right. If you're going to get a benefit somewhere, there's got to be a risk somewhere else. Right? There's always risk adjusted return in everything that we do. Similar to an HSA there's no guarantee that you could end up if you need access to that money and you need to withdraw early penalty if you're not using it for qualified expenses and you get audited, you could be, you know, incurring tax.
Right. So it's identifying, you know, the risks of, of entering those accounts, and just having the knowledge to know, like, okay, what is the downfall if I needed access to that money before it's qualified.
Right. And if I don't have the right expense to basically properly offset that distribution.
And then you mentioned that there's, you know, a strategy with a singular tax benefit. What are those?
So non-qualified annuities. Right. Meaning that it's an annuity that's not purchased in an IRA or tax deferred account. With a non-qualified annuity you are using after-tax dollars to put in that gets to grow tax deferred. Right. So you're not paying any tax on any of the income or gains that, that, annuity is, is accruing. But then when you make the distributions, those are taxable distributions.
Anything that you already paid the taxes on the money going in. So that's that's your basis.
So as we think about the hierarchy in terms of how somebody should be thinking about contributing to some of these accounts, you've got, you know, the 401K whether it's pretax or Roth, you got the health savings account. You potentially have, you know, 529 if you're saving for your kid's education like we are, you've got your traditional brokerage account because you want to build up a nest egg. So that way you can you buy a house or do other things. There's a lot of decisions somebody needs to make as they're in the accumulate phase. How would you go about determining which accounts to contribute to first? All the way to last?
And so there's no one right answer to that. Right. It's important to have a plan set out to understand what you're trying to accomplish and then create that plan based on those goals. But from a high level, the best hierarchy is one- you shouldn't be investing anything if you don't have an emergency fund set up, right?
So make sure you have money set aside. And normally, if you're a single income household, that's at least six months of non-discretionary spending. If you're a dual income household, that could be 3 to 6 months, of cash set aside. But if you're entrepreneurial or if you're an extremely high income earner, that might not be enough. Because if you lose your job and you're an extremely high income earner, it might be hard to replace that.
So even knowing this scenario, or if you're entrepreneurial and you might want to start a business, people like that and maybe have 12 to 18 months of cash set aside and it could be put in the money market. It doesn't have to just sit in cash. It could still be reccurring interest.
I think about those real estate agents that went through that financial crisis. I mean, it was a couple years before mortgage brokers, real estate agents probably made that type of income.
So understand your scenario, right. And then understand what you're comfortable with as far as an emergency savings, where you're not going to be stressed because, I mean, there's statistics that show people that have more cash are happier people, and it's because they're not stressed day to day. If something were to happen, they know they've got a backup plan.
So first establish that emergency fund. Then we can start looking at investing. And that's if you're in a qualified, plan, a company-sponsored plan that provides a match, because the first thing you're going to want to do is get free money. So maximize whatever employer contributions or employer match that you can. Yeah.
They match 3%. You're doing at least a 3% contribution. So they're going to match 1% on 1% for that. Yeah. Now once you've maximized the employer match, you don't want to go on investing more until you've identified your debt. So now we're going to look at your high interest debt. If you've got a lot of credit card debt, you shouldn't be investing money until you've paid that off.
You would quantify high interest debt as any debt where you're paying higher interest rate above seven, 8 or 9%.
Yeah. If you're looking at a traditional portfolio, you know, annualized returns over a long period of time, if you're paying over 7% debt, you should pay that debt off first, and then you know, be able to invest any discretionary money that you have.
So that's helpful to think about the right. I want to make sure I have an emergency fund to take care of my needs. I then don't want to give up on free money. And then I want to make sure that, you know, I'm not paying any high interest debt and wasting money from there, let's say, money's left over from that.
How would I go about thinking about what's next?
So now you want to maximize contributions to either that company plan that you're in. So if you do have the ability and you're a high income earner and you've got a, a high deductible plan, now you're balancing okay, I should max out my, my HSA and I should max out the contributions to, any employer sponsored plan.
Or if you're self-employed, There's IRAs and other options.
Now there's limits to for you to be able to contribute to like a Roth IRA, directly. And so if you make over $146,000 as single or $230,000 married, filing joint, it may limit your ability to access and contribute directly to a Roth IRA, but not a Roth 401K.
In a Roth 401K, there is no, there's no income limit because it's a company sponsored plan. Yeah.
And I struggle with this one because we don't really know where tax rates are going to be in the future. But if you're a very high income earner, you could justify the reasons for a tax benefit today. But you know, it shouldn't just be one or the other. I strongly feel that maybe people should be building up both buckets.
I mean if you're young and your income's low, maybe put more of a higher percentage to the Roth 401K. Yeah.
But you know, I think people I think people look at it as a zero sum game where they think, oh, I either should, invest in a traditional or a Roth, when in reality there's no reason you can't put 50/50 and build both buckets. So you have better tax planning and better tax strategy when you do get to retirement, because you got multiple buckets to pull from.
But if you are in the highest tax bracket right now, it's pretty beneficial to be able to use that traditional, whether it's a 401K or IRA and not pay that 30, you know, plus percent on those dollars today knowing that most likely you're going to be now it's not guaranteed, and who knows where taxes are going to be in the future, but most likely when you're retired and you don't have earned income, you're going to be in a lower tax bracket. Yeah. But that doesn't mean you put all your eggs in one basket, like identify opportunity to build that Roth and but take advantage, especially if you're in the top tax bracket take advantage of that tax it.
Yeah I especially think about how expensive it is these days to purchase a home or to raise kids. You're going to need somewhat of that tax break to be able to save additional dollars, to be able to fund a 529, to be able to save for a down payment on a home.
Well, that's where like that's why you got to deviate from, you know, that hierarchy every now and then because it's all dependent on what's most important, you know, to you and your life right now. If the most important thing is, getting into a new home because you've outgrown your home, your family's growing, well, then you don't want to lock up your money into tax-deferred accounts, because you're going to get penalized if you try to access those. For the most part, there's a little bit that you could pull out in a 401K for a first home and so forth, but you don't want to even put yourself in that situation.
So identifying your goals first and then getting through, you know, you've got your emergency account, you've maximized, the employer match, you've paid off your debt. Well, now, maybe it's not contributing more to, your retirement plans. Maybe now it's building up a brokerage account that you're putting in safe money because, you know, in 3 to 5 years, you're going to need that down payment for, you know, the next house.
But that's where the planning is.
Important, and that's where you're weighing the sacrifice of saying, hey, by not contributing as much to my retirement today, I might have to work for an extra few years in the future, but at least I'm saving enough. So that way I can, you know, buy that home and have a place.
And there's also that, you know, theory where buying that home, you're now going to get appreciation in real estate over the long run where you're still building wealth. And, you know, you're not paying, you know, taxes on the appreciation of that growth. So there is some tax deferred growth there and the appreciation of that asset.
But I've seen a number of articles recently that was talking about that whole fire movement, that financial independence retire early. And this is where people save, you know, upwards of 80% of their income today. So that way they can walk away from a job and enjoy retirement. But what some of these articles have pointed out is the life events and the experiences that they're foregoing with their spouses and their families today just so they could retire early, some of them said, hey, that's not worth it.
I'd rather build a career, be able to enjoy my life a little bit more today, as opposed to have to sacrifice so much just so I could walk away from a job at 50 versus 60.
You are taking away a lot of your options if you're planning on, taking that route to an early retirement, because you're also setting yourself up for a very limited retirement experience where you're going to be on a budget the whole time you're retired. Right. And there's nothing wrong with that for some people. But it it eliminates optionality. It eliminates, freedoms that, you know, if you just are established in a career and you're balanced in putting away money for your future, but enjoying today and getting those memories and experiences today that you're never going to get back because we're only, you know, this old once.
Well, I think one reason why a lot of those articles have been coming up recently is because just over the last few years, inflation has really, you know, become a headwind for many people. And the ones that sort of were on this path for financial independence, retire early- they realized that even though they saved enough at the time to retire, inflation has now caused them to rethink that and say, oh, wow, I need to go back to the workforce and save more, because inflation could be the one factor that I didn't properly plan for.
Yeah. So when you're talking about planning, obviously you talked a little bit about the short term, making sure there's an emergency fund, getting rid of short term debt, taking advantage of accessing free money through company match and 401Ks. How do you weigh the balance between that goal of owning a home in the next five years versus saving towards retirement, you know, which might be 25 or 30 years away?
I mean, that's a tough question because it's all based on individual preference. And what's right for that in particular, you know, person or family. Yeah. But I think having a balanced approach helps where you're not doing all in one bucket, where if you know that you want to get into a house, then you start putting away, you know, 60% of your discretionary income into that bucket, but you're still able to start to slowly build up the retirement plan so that you don't just put everything you're still getting tax deferred growth in the retirement accounts, you're still working towards your overall retirement goals, maybe not contributing as much as you could have, but you're attacking both buckets as opposed to all or none.
Which is some of the common mistakes that you and I talk about people do. It's just that singular focus. It's sort of an all or nothing mentality. But the reality of life is that life comes with a lot of sacrifice. If you want something in life, you're going to have to sacrifice something else in order to do it and deal with those consequences.
Yeah, and those consequences aren't necessarily bad. It's just part of life.
And it just means that that could be fine, that you're putting away more for now, but then you're going to have to play catch up later and having that realization, knowing that you're going to have to work hard to put away more, to get caught up to where you need to be. As long as you're aware of it and you plan for that and you emotionally, you know, that's something you're going to deal with because you made that sacrifice now. That's the important part about having a relationship, with a financial planner or, you know, an investment advisor to help identify these, these things and help, you know, what these are emotional decisions that can be really impactful.
Yeah. And look at the money that we're saving and we're investing. It's tied to something that we have emotionally that we want to eventually do with that money. So that money comes with a purpose. We're not an institution that's trying to live on forever that's not emotionally tied to the dollars that we see in an account. So we have to come to the realization that our emotions are going to affect these things.
But creating a plan, having the right strategy and customizing it for you and not just doing whatever your friend is doing probably makes the most sense. What are some other common mistakes, if you can think of, that people might make when it comes towards saving in one of the vehicles, whether it's a 401K, HSA, brokerage account, what are some other common mistakes that you see people make?
We've identified a few of them, right? Where I feel like there's a lot of high income earners that don't take advantage of an HSA because they don't want to be in a high deductible plan. And you don't have to be a high income earner to take advantage of an HSA but I see it more with high income earners where they're thinking, why would I want to go into a high deductible plan?
Where I have got, you know, an employer that's offering this great plan with these low deductibles, right? And so it's sitting down and getting them to really understand the power of that, that HSA and being able to, you know, accumulate wealth in that bucket where they want to have opportunity.
Another one, it comes down to the Roth. There's a lot of, high income earners, too, that assume that because they have the ability to to put into a Roth IRA or a Roth 401K because there are no, limits on income in that account that they should. And yeah, I see people who are in the highest tax bracket now that are putting into the Roth and not taking, you know, any benefit of being able to reduce their taxable income now.
And I'm not saying there's one right answer to it, but it's at least worth having the conversation not being so dogmatic. And oh, this is what I should do because this is my scenario.
The reality of that is if you're making $750,000 or a million a year and you're in the highest tax bracket, well, that's assuming you're going to be making 750,000 or $1 million a year in retirement. And that tax rates haven't changed at all. But if a lot of your money is now in this Roth account, that's tax free when you take it out, your income might not be as high right?
Yeah. And that's why. But I think that there's a balance there where you should understand what tax benefit do I want now and what tax benefit do I want later. Yeah.
I love that. And I know we talked a little bit about the different types of accounts and, and what's available to you, but really making sure that you've got that emergency fund, you're taking advantage of free money, you're in an HSA account, but actually contributing to it. You don't want to be in a high deductible plan and not be contributing to the HSA, then determining about, you know, taking care of high interest rate debt and saving for your current needs in the next few years through a brokerage account versus your long term.
All of this comes back to having a personalized plan for you, which is something that we're happy to sit down and talk to anybody about.
Yeah, absolutely. And, you know, it's what's so fun about our job is not having, you know, one answer for every problem, every relationship that comes in here, every family that we get to work with, we get to develop a unique solution set.
I love the fact that we work in this industry, not only because it helps me be knowledge about the ways to take advantage of some of these things. But I wish our clients and our friends and family could hear how much we actually talk about the problems that we're trying to solve for each other day in, day out, and so it's nice to have great resources.
Disclosure: The information discussed herein is foreducational purposes only and is not intended to constitute financial advice.This information should not be relied on for investment recommendations. Theviews and opinions expressed by the speakers are as of the date of therecording and are subject to change. Morton makes no representation that thestrategies described are suitable or appropriate for any person and should notbe assumed that Morton will make financial recommendations in the future thatare consistent with the views expressed herein. Past performance is noguarantee of future results. Information contained herein is not written orintended as tax advice and may not be relied on for the purpose of avoiding anyfederal tax penalties under the Internal Revenue Code. You are encouraged toseek tax advice and/or financial advice from your financial advisor and/or taxprofessional before implementing any transactions and/or strategies concerningyour finances
