Invest Simply And Wisely Using A Waterfall Of Tax-Efficient Accounts

Invest Simply And Wisely Using A Waterfall Of Tax-Efficient Accounts

March 16, 2023

The first, and by far the most important, step in building wealth is setting your savings rate. We recommend adopting and implementing a cash flow system to help sharpen your savings calculations. A good cash flow plan should help you determine the best balance of spending on important things like education and travel while saving enough for an emergency fund, paying off debt and building up a retirement nest egg. We recommend saving 10%-40% of gross pay into retirement accounts, depending on your age, income and goals.

The next step in investing is determining how best to utilize the various retirement accounts available to you. We recommend following a tax efficient waterfall, filling up each bucket before moving to the next level down. The precise waterfall will vary based on your specific circumstances, but there are some general rules of thumb.

We start the waterfall by making sure you claim any free money from any matching contributions in employer retirement plans. Then we recommend paying down high interest debt, like credit cards, to get an attractive, guaranteed return that positively impacts your net worth.

For folks with high deductible health plans and in relatively good health, a health savings account (HSA) has triple-tax benefits that makes it a great long-term retirement account—contributions to an HSA are tax deductible on the front end, investment income is tax deferred as it grows, and withdrawals are tax deductible if used for health expenses. And who doesn’t have high health expenses in retirement? If you use an HSA for retirement savings, make sure to set aside money for your near-term healthcare costs.

Next, we typically recommend maxing out our pre-tax contributions to qualified retirement plans (401(k)s, 403(b)s and governmental 457(b)s). Younger people may want to consider the Roth 401(k) option if available, but most people will want to avoid taxes now.

For tax diversification—to balance out your eventual retirement plan withdrawals that will be taxed as ordinary income—we would then look to contribute to Roth IRAs, either directly if under the income limits (of ~$230,000 in adjusted gross income for married tax filers in 2024) or through the “backdoor” if over those limits. In a backdoor Roth, you contribute to a non-deductible traditional IRA then, almost immediately, convert it to a Roth.

Before moving down the typical waterfall you should make sure you’ve looked at any other tax-advantaged accounts that might be available to you, including cash balance plans, non-qualified deferred compensation plans, solo 401(k)s, or “mega backdoor Roths” (employer retirement plans that allow non-Roth, after-tax contributions and in-service withdrawals/conversions into Roth IRAs).

You might also consider investing in real estate or other “alternative” investments. Since some these alternatives generate significant income, you might explore the possibility of setting up a self-directed solo 401(k) or IRA to reduce the tax consequences.

High earners and super savers will eventually run out of tax-advantaged accounts, and invest in a regular taxable brokerage account. We recommend tax-efficient index mutual funds or exchange-traded funds that don’t generate significant capital gains so you are generally only paying taxes on bond income and stock dividends, often at favorable rates. If your marginal income tax rate is high, you might include tax-exempt bonds in your portfolio and/or place more of your bond holdings in your tax-deferred investment accounts.

You can also think about making extra principal payments on your mortgage or paying down other lower interest debt. We hope you would do better over the long run investing in a stock/bond portfolio than paying down a 3.5% interest mortgage, especially if you are able to itemize and take the mortgage interest deduction, but there’s great psychological value in slaying debt. More recent mortgages, which might carry a 6%-8% interest rate, are higher priorities for directing extra cash flow toward extra principal payments.

The last, and probably the easiest, step in investing is buying an appropriate mix of assets. We encourage our clients to capture broad market returns across a range of asset classes utilizing low-fee index funds. Target retirement index funds are a great option for most individual investors in their work retirement plans. Target retirement date funds from Vanguard, for example, include an age-appropriate, diverse mix of U.S. stocks, international stocks, U.S. bonds and international bonds. The funds continually rebalance to maintain a suitable asset mix and automatically adjust the mix over time to become less risky as you near retirement age. Target retirement date funds allow you to “set it and forget it,” so that you can focus on your day job. For those that need or desire more control over their investments, you can buy a comparable mix of individual index funds.

Bottom line: keep it simple, understandable and effective. As DIY proponents, we believe we can coach our clients to avoid those instinctual moments of panic. If you save appropriately and invest simply and wisely, you will eventually reach your retirement goals. You can do it yourself, but you don't have to do it alone.