Tax Strategies: Getting the Most from Your Money

"The hardest thing in the world to understand is the income tax." - Albert Einstein

Today we will talk about something that might not be the most exciting topic but is super important for your financial health: taxes. Specifically, how different types of accounts are taxed and why balancing them can save you a lot of money in the long run.

Imagine your money as a team of superheroes. Each superhero has a unique role and contribution, but if they don’t work together, you might end up losing the fight. The challenge here is maximizing your financial health while minimizing your tax burden. Let’s meet the superheroes: Spider-Man aka Tax Now, Iron Man aka Tax-Deferred, and Captain America aka Tax-Advantaged accounts.

Meet the Team

Spider-Man (Tax Now Accounts) are your checking and savings accounts, and taxable brokerage accounts. The money in these accounts gets taxed every year and forever on any interest or gains. The problem is if you have too much money in these accounts, you’re paying more in taxes each year than you need to. If you have high annual tax bills and less disposable income because Uncle Sam is taking a big cut, you may have given Spider-Man too much. You are missing out on taking advantage of tax-deferred growth and other tax benefits. The answer is to diversify! Spread some of that money into tax-deferred and tax-advantaged accounts and consider tax-efficient investment strategies like tax-loss harvesting.

Iron Man (Tax Deferred Accounts) Traditional 401(k) and Traditional IRA. Money in these accounts grows tax-deferred, meaning you don’t pay taxes on it until you withdraw it in retirement. Relying too much on these accounts can lead to significant tax liabilities when you start taking money out in retirement. This can be a real shock to your system if you’re not prepared. You might see high required minimum distributions (RMDs) once you hit 73 years old (as of 2024), which can lead to large tax bills. Additionally, these withdrawals might push you into a higher tax bracket, resulting in even more taxes! If you don’t have a balanced approach, you might find yourself lacking tax-free income sources in retirement. This can result in an unexpectedly large tax burden when you need your money the most. One way to mitigate this is by considering Roth conversions at strategic times, converting some of your tax-deferred money into tax-free money. Balance your withdrawals between tax-deferred and tax-exempt accounts to manage your taxable income effectively.

Captain America (Tax-Advantage Accounts) These include Roth IRAs, Roth 401(k)s, Health Savings Accounts (HSAs), and 529 plans. Contributions are made with after-tax money, but qualified withdrawals are tax-free. Not utilizing these accounts means you’re missing out on the opportunity for tax-free growth and withdrawals. This can significantly reduce your overall retirement savings. If you’re paying more in taxes than you think you should be, and your retirement savings aren’t growing as quickly as you’d like, you might not be using tax-advantaged accounts to their full potential. A clear warning sign is having a high taxable income without the offset of tax-free withdrawals. This indicates that you’re paying more in taxes than necessary and not leveraging the benefits of these accounts. Maximize your contributions to Roth IRAs, HSAs and cash value life insurance. These accounts can provide significant tax advantages, especially in retirement. Planning ahead can ensure you have a mix of tax-free income sources to complement your tax-deferred and taxable accounts.

The Balancing Act: Achieving a Tax-Efficient Portfolio

So, how do you put all this together? It’s all about balance and diversification. Aim to balance your contributions among Spider-Man, Iron-Man, and Captain America accounts. Evaluate your current and future tax brackets to decide the best mix for you. Regularly review your portfolio and adjust your contributions as your financial situation changes. Stay informed about tax laws and changes that may affect your accounts.

Don’t hesitate to seek professional guidance. A financial or tax professional can help you navigate the complexities and ensure you’re making the most of your money.

Balancing how your money is taxed is like balancing your diet – you need a bit of everything to stay healthy. By spreading your money across different types of accounts, you can reduce your tax burden and keep more of your hard-earned cash. So, take a look at your financial superhero and make sure they’re fighting together to win.

Remember, it’s not just about how much you earn, but how much you keep after taxes. Happy balancing, and here’s to a financially healthy future!

Download “How Your Money is Taxed” document for free.