Tax optimization in accumulation phase
This post is part of the Financial Freedom Guide series
You've set your sight on Financial Freedom and are working to build up capital. Here are some of your key tax optimization strategies during the accumulation phase:
Move to a high income, low tax, low cost jurisdiction
If your income is low while your taxes and living costs are high, it can be incredibly hard to reach "escape velocity" and accumulate sufficient capital to achieve Financial Freedom.
To perhaps unfairly(?) pick on one such location, consider London, UK:
London entry-level salaries are very low compared to living costs - even Oxbridge graduates can count themselves lucky if they start out on GBP 40,000 per year
London is expensive - many young folks end up sharing housing with a lot of other people and can barely afford to go out, never mind save
Tax rates quickly exceed 40% once you start doing better - and that's before considering 20% VAT and council taxes
So if you can, consider relocating and setting your finances on a much easier path to Financial Freedom, even if just for a few years. I laid out my humble opinion of a few of the best options here: Where to make your fortune (coming soon - subscribe to encourage us to hurry up). Because remember, it's all about your savings rate!
Maximize tax-advantaged retirement accounts
This will be US-specific for a minute. Feel free to skip ahead to Minimize taxes on investment income if US retirement accounts don't apply to you:
Step 1: Decide whether you want to prioritize Traditional OR Roth contributions
Revisit Account types for a refresher. This decision comes down to your expected personal marginal tax rate today vs in future years:
Expect lower marginal tax rates in the future? Contribute Traditional funds today.
Expect higher marginal tax rates in the future? Contribute Roth funds today.
Your marginal tax rate may change either (a) due to differences in your income level (given progressive tax rates), or (b) because of tax rate hikes/cuts.
As a simple rule of thumb (for most people in 2021), I would prioritize Traditional contributions if your marginal combined federal, state, and local income tax rate is above 20%, and Roth contributions if your marginal tax rate is below 20%. This is because if you play your cards right, you may be able to shift your taxable income into future years in which you pay tax rates below 20% - even all the way down to 0%.
Here some examples of why your marginal tax rate may go UP in the future:
Your career takes off and you earn a lot more money (and, critically, continue to do so into your 60ties)
You move to a high-income tax state like California
Congress and/or your state decides to hike tax rates - they are historically low at the federal level right now, so it stands to reason this will happen eventually, OR
You made a lot of Traditional contributions over your lifetime (saving taxes along the way), never found yourself in a low income situation all the way into your 60ties, and/or never made any Roth conversions. You are now approaching age 72 and Uncle Sam finally wants his due, mandating Required Minimum Distributions (RMDs) that push your taxable income to new heights. I'm sorry! Console yourself knowing this is a rich person's problem - but perhaps unnecessary.
But your marginal tax rate can also go DOWN, for example because:
You achieve Financial Freedom long before age 72 and shift from high earned income taxed at ordinary rates to smaller amounts of investment income taxed at preferred capital gains tax rates
Better yet, you move to enjoy the good life in a no income tax state - or a low/no tax jurisdiction abroad
You take time off to raise your kids, have a period of unemployment, or simply enjoy a sabbatical to pursue your passions.
If you expect any of the latter scenarios for yourself, consider prioritizing Traditional contributions now. If you don't know what your future holds, consider diversifying, spreading your bets across Traditional, Roth, and regular taxable brokerage balances. That way you remain flexible and benefit from whatever life throws at you.
Step 2: Max out any employer 401(k) contribution matching
Free money is free money. Don't be silly.
Step 3: Max out your Traditional contributions if your total marginal tax rate will be lower in the future
In most cases you'll want to max out your/your spouse's IRAs - if your income is low enough for contributions to be deductible - then make additional contributions to your 401(k) to max that out as well. Revisit Account types for details.
Step 4: Max out Roth contributions
First your/your spouse's Roth IRAs - if you haven't already maxed out your combined IRA contribution limit with contributions to your Traditional IRAs, and if you are eligible to make Roth IRA contributions. Then your 401(k) if it allows Roth contributions and you haven't already maxed out your employee contribution limits with Traditional contributions. Revisit Account types for details.
Step 5: Maximize backdoor Roth strategies
Make Nondeductible and/or After-Tax Voluntary contributions and then convert to Roth. Revisit Account types for details.
Step 6: Save and invest even more money in your regular brokerage account
If you are able to max out all of the above steps several years in a row, you are pretty much guaranteed to achieve Financial Freedom very quickly as you'd save and invest in 2021 alone:
$6,000 in each of your and your spouse's IRAs ($12,000 total)
$58,000 in each of your and your spouse's 401(k) ($116,000 total)
Plus any catch-up contributions for those turning 50 or older
Any amount in your regular brokerage account(s)
For a grand total of $128,000 ($64,000 for singles) or more saved in retirement accounts that year, plus any savings invested your in regular brokerage accounts.
Even if you cannot reach these lofty targets, put aside as much as you can in tax advantaged retirement accounts to accelerate your path to Financial Freedom.
Minimize taxes on investment income
Place your assets in the most tax efficient accounts
As a simple guide, here is what kind of investments you want to hold in which kind of account:
Taxable accounts: Low tax investments - avoid ordinary income tax rates in taxable accounts by moving your bonds, REIT, and any non-US stock investments, none of which are eligible for lower capital gains tax rates, to retirement accounts.
Traditional funds: High tax, low growth investments - your earnings won't be taxed today but will when you withdraw or convert in the future. Perfect for bond and/or REIT investments.
Roth funds: High tax, high growth investments - your earnings won't be taxed today or tomorrow. Perfect for anything! Use Roth funds to "hoover up" anything you don't want in taxable or Traditional retirement accounts.
Minimize taxes when rebalancing
As we have seen, rebalancing is a fantastic tool to increase your returns and reduce risk. Rebalancing involves selling some of your "winners" to buy more of your "losers" with the knowledge that the fortunes of uncorrelated assets tend to reverse over time. When rebalancing, try to avoid actually selling any securities.
Instead, especially when you are in accumulation phase, add new funds to buy more of the assets that are currently below their target allocation and rebalance that way.
Similarly, be smart about how you reinvest your interest and dividends. Instead of reinvesting them automatically into the same asset they came from, consider using them to buy more of the assets that are currently below their target allocation to rebalance.
If adding new funds and being smart about how you reinvest your interest and dividends isn't enough, use "specific identification" ("SpecID") to pick the best tax lots to sell. You will likely have bought the same (or equivalent) securities a number of times at different prices. Your broker should allow you to chose which of these specific "tax lots" you want to sell. If your current tax rates are high and you aren't looking to tax gain-harvest, simply sell the specific tax lot(s) with the highest basis (purchase price), resulting in the lowest taxable capital gain.
Tax loss-harvesting
Your investments will swing in price all the time. Sometimes that means they drop below the price for which you purchased them. Rather than curse the markets, you can make use of this golden opportunity:
Wouldn't it be pretty clever to sell the losing security to realize a capital loss on paper (to "harvest the loss" for tax purposes), only to immediately re-buy the same or equivalent security to stay invested and ride the upswing? Yes!
In fact, you can use capital losses not just to offset capital gains but also up to $3,000 a year in ordinary income (e.g., wages) on your US tax return.
The government isn't stupid though. They figured this game out a hundred years ago and created the "wash sale rule" to limit this strategy’s appeal. A wash sale occurs when you sell a security at a loss and then rebuy the same or a "substantially identical" security within 30 days before or after the sale. And no, you don't want to stay out of the market for 30 days, only to find your desired investment has moved higher/ against you.
So at this point you may be wondering why I took you down this rabbit hole. Turns out that despite the wash sale rule, the tax loss-harvesting game is alive and well. It all comes down to the definition of the term "substantially identical".
The advent of mutual funds - and specifically index funds - created a loophole that the US government has yet to eliminate. Simply put, the IRS has never treated index fund shares from different issuers as "substantially identical" securities (even when they track the same or equivalent indices).
Want to harvest a loss on Vanguard's Total US Stock Market Index Fund (ETF ticker: VTI)? Easy, simply sell and immediately replace your position with Schwab's US Broad Market Index Fund (ETF ticker: SCHB). Sell one, buy the other. Sure, one is issued by Vanguard and tracks the "CRSP US Total Market Index" and the other is managed by Schwab and tracks the "Dow Jones U.S. Broad Stock Market Index". While that may sound very different (and ergo not "substantially identical"), both index funds are nearly perfectly correlated as they hold almost exactly the same underlying stocks in almost exactly the same proportions. In other words, you are invested in the almost exactly the same thing. You can find more of these equivalent ETFs here.
Now the government may close this loophole at any time but until then this is such big business that financial advisors, including robo-advisors, tout their tax loss-harvesting services as one of their core value propositions. The good news is, now you already know how to easily do it yourself!
Please comment below if you have questions or your own tax optimization tips to share!
Go back: How do I optimize taxes?
