MYM #013: Where YOU need to be Putting Money (Tax-Buckets)

In this week's newsletter, we're diving into a topic that can significantly impact your financial strategy: The 3 tax buckets. 

Tax Deferred, Taxable, and Tax-Free. We'll explore the unique characteristics of each, how they affect your investments, and strategies to make the most of each bucket based on your financial goals.

Understanding the different tax buckets is crucial for minimizing tax liabilities and maximizing your after-tax returns. By strategically allocating your assets among these buckets, you can effectively manage your tax obligations and potentially grow your wealth more efficiently.

Many individuals miss out on opportunities due to a lack of understanding about the tax implications of their financial decisions. Without a grasp of the tax buckets and how they operate, people might unintentionally expose themselves to higher taxes or miss out on tax advantages that could positively impact their financial future.

We have seen countless situations were people's Net Worth is 100% in their 401k, which is 100% taxable in the future (we will dive into why this is BAD later.) Today we're going to ensure you don't make the mistakes other's have made!

Key Points:

1. Tax Deferred

2. Taxable

3. Tax-Free

Tax-Deferred Assets: Tax-deferred assets are investment accounts where you can delay paying taxes on your contributions and earnings until a later date, typically during retirement. Common examples include Traditional IRAs and 401(k)s.

Pros:

• Immediate Tax Benefits: Contributions to tax-deferred accounts can lower your taxable income in the year of contribution, potentially reducing your current tax bill.
• Earnings Grow Tax-Free: As long as your money remains in the account, you won't pay taxes on the investment gains, allowing your money to compound more effectively.
• Ideal for Retirement Planning: Tax-deferred accounts are particularly valuable for retirement planning as they enable you to accumulate wealth over your working years and potentially withdraw it at a lower tax rate during retirement.

Cons:

• Tax on Withdrawals: When you withdraw funds from tax-deferred accounts, you'll owe income tax on both the contributions and earnings. This can be a disadvantage if your tax rate is higher in retirement.
• Penalties for Early Withdrawals: Withdrawing funds before a certain age (usually 59½) can result in penalties and additional taxes.
• Required Minimum Distributions (RMDs): Starting at age 72, you must begin taking required minimum distributions (RMDs) from tax-deferred accounts, which can impact your retirement income and tax liability.

Taxable Assets: Taxable assets are investment accounts where you invest after-tax money, and you may incur taxes on any earnings or capital gains during the holding period. Common examples include individual brokerage accounts and savings accounts.

Pros:

• Flexibility: Taxable accounts offer maximum flexibility as there are no contribution limits or restrictions on when you can access your funds.
• Capital Gains Tax Control: You have control over when to realize capital gains, allowing you to strategically manage your tax liability by choosing when to sell investments.
• Diverse Investment Options: You can invest in a wide range of assets, including stocks, bonds, real estate, and more, providing diverse investment opportunities.

Cons:

• Tax on Capital Gains: You may owe capital gains tax when you sell investments at a profit, potentially reducing your overall returns.
• Tax on Dividends and Interest: Earnings from dividends and interest are typically taxed at your ordinary income tax rate, which can be higher than the rate on qualified dividends or long-term capital gains.
• Limited Tax Advantages: Taxable accounts lack the tax benefits and deferrals available in tax-advantaged accounts like IRAs and 401(k)s, potentially resulting in higher taxes over time.

Tax-Free Assets: Tax-free assets are investment accounts or vehicles where you can contribute after-tax money, and qualified withdrawals are entirely tax-free. Common examples include Roth IRAs and Health Savings Accounts (HSAs).

Pros:

• Tax-Free Growth: Investments in tax-free accounts grow entirely tax-free, allowing your money to compound without incurring capital gains or income tax.
• Flexible Withdrawals: You can withdraw contributions (not earnings) from Roth IRAs at any time without penalties or taxes, providing flexibility for financial needs.
• Diverse Uses: Tax-free accounts like HSAs can be used for healthcare expenses, while Roth IRAs are versatile and can serve as both retirement and emergency savings.

Cons:

• Contribution Limits: Tax-free accounts often have annual contribution limits, which can restrict the amount you can invest each year.
• Income Restrictions: High earners may be restricted from contributing to or fully benefiting from certain tax-free accounts like Roth IRAs.
• Penalties for Non-Qualified Withdrawals: Withdrawing earnings from tax-free accounts before age 59½ or for non-qualified expenses may result in penalties and taxes.

Many people always ask about what they need to know regarding Roth IRAs (the most popular tax-free bucket asset). Here is a fantastic thread from a fellow adviser outlining everything you need to know:

 So - we've dove into the details surrounding tax-deferred, taxable, and tax-free buckets & the pros/cons of each one. Naturally this poses the question... which do we use?

Answer: It depends! Every situation is naturally different. But there are important uses for each bucket. In an ideal world we can take advantage of all three tax buckets, and carefully utilize the benefits of each one in order to put ourselves in the best position to succeed financially.

I have no idea what the tax code is going to look like in 30 years, and neither does anyone else! Therefore we want to diversify our tax-buckets just like how we diversify our asset allocations inside our investments.

We want to be getting the best attributes of each of these buckets, and hence can plan for how to be most tax-efficient down the line while maximizing growth of your overall wealth in the meantime.

 Here is just one client example showing just how powerful knowing when to pull from each tax-bucket can be. Nearly a MILLION dollar difference in just having the option to pull in a tax-efficient manner:

Lastly, here are some key considerations we need to make when it comes to analyzing which buckets we should utilize:

1. Financial Goals and Time Horizon:

   • Consider the specific goals you're saving for, such as retirement, education, buying a home, or emergency funds.
   • Assess the time horizon for each goal, as this influences your investment strategy and the choice of tax buckets.

2. Current and Future Tax Bracket:

   • Examine your current income tax bracket to determine whether you could benefit from immediate tax deductions (e.g., contributions to tax-deferred accounts) or if you're in a lower tax bracket now and anticipate a higher one in the future.
   • Predict your future tax bracket during retirement or when you plan to withdraw funds to make informed decisions about tax-free or tax-deferred accounts.

3. Liquidity Needs:

   • Evaluate how soon you might need access to your funds. Taxable accounts provide the most flexibility for accessing money at any time without penalties, making them suitable for short-term goals or emergencies.

4. Contribution Limits and Eligibility:

   • Be aware of annual contribution limits for tax-advantaged accounts. For example, there are limits on contributions to IRAs, 401(k)s, and HSAs.
   • Ensure you meet eligibility criteria for certain accounts like Roth IRAs, which have income restrictions.

5. Tax Efficiency of Investments:

   • Consider the tax efficiency of your investments. Tax-inefficient assets, like high-yield bonds or actively managed funds generating frequent capital gains, may be better suited for tax-deferred or tax-free accounts to minimize annual tax liabilities.

6. Diversification and Asset Allocation:

   • Diversify your investments across asset classes and accounts to manage risk effectively.
   • Allocate investments based on the tax efficiency of the asset, placing tax-inefficient assets in tax-advantaged accounts.

7. Required Minimum Distributions (RMDs):

   • Understand the impact of RMDs from tax-deferred accounts starting at age 72 and plan how to manage these distributions.

8. Estate Planning:

   • Consider how each bucket fits into your estate planning strategy. Tax-free accounts like Roth IRAs can provide tax-free inheritances for your heirs.

9. Tax Law Changes:

   • Stay informed about changes in tax laws and regulations that may affect the tax treatment of different account types.

 We know it's a pain trying to figure this stuff out. But just like every other financial planning process - we need to get ahead of the game and figure this stuff out early. Reach out to your trusted advisors & be sure that you are taking advantage of everything you can to maximize your financial situation both now & in the future!

Actionable Tip: Assess your financial goals and timeline to determine which tax buckets align best with your needs. Consider factors such as your current tax bracket, retirement plans, and short-term objectives.

Develop a tax-efficient investment strategy that capitalizes on the unique advantages of each bucket. To maximize tax savings, seek advice from your trusted advisors who can help you make smart decisions for both now & your future.

Whenever you're ready, there are 2 ways we can help you:

​1. The Master Your Money System: Transform your personal finances into an automated machine with our Master Your Money system. This comprehensive video course will teach you the automated system we use to serve our millionaire private client base to maximize every dollar earned.

2. Become part of our private client group. If you’re in your 30’s or 40’s, earning more that $150,000 of income, and looking to maximize every dollar earned, but need speed and convenience, consider booking a meeting with us to see if we should join forces to work one-on-one.