Tax-free Investment Accounts and How to Maximize Them

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Tax-free Investment Accounts and How to Maximize Them

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When trying to maximize returns, most investors only focus on the investment selection, i.e. which stocks to buy. While this is very important, another important factor is commonly overlooked – are the investments inside a taxable account, a tax-deferred account, or even better, a tax-free account? Taxes affect overall returns.

There are many ways to invest via accounts that are all taxed differently.

Most of us are familiar with regular, taxable accounts where capital gains taxes apply in the year they are realized.

Most of us are also familiar with 401Ks and Traditional IRAs, where income taxes apply when distributions are taken from the account.

Many of us are also familiar with Roth IRAs and Roth 401ks, where growth and distributions are generally tax-free.

So why don’t we all just invest everything inside tax-free accounts and avoid the accounts with taxes?

The government restricts the amount that can be contributed to tax-free accounts (Roths) and imposes income limits. So, if you make over a certain amount, you generally cannot contribute directly to a Roth. If you are under the limit, you generally can contribute the maximum, currently $6,000 per year. The government does not allow you to contribute more than $6,000/year directly to a Roth because they don’t want all your money and investments to be tax-free. They want to keep most of it taxable so that they continue to collect taxes on it into the future.

If you are over the income limits, there could be different ways to invest inside a tax-free retirement account. If this applies to you, let us know and we can help address it.

Beyond that $6,000 direct contribution limit, there are more ways to boost your contributions to tax-free accounts.

Another post describes the Roth conversion and the back-door Roth, which may or may not get scrapped by current pending legislation (October 2021).

Here we’ll focus on Roth 401Ks and on After-tax 401Ks. There is a difference.

Generally speaking, here’s what you might be able to do:

You, the employee, are allowed to contribute a combined maximum of $19,500 to regular and Roth 401ks. So, let’s assume that your employer (or your own company if you are a business owner) matches 100% up to 3% to a regular pre-tax 401K. And let’s assume that 3% is equal to $3,000 ($100k salary).

In this example, for the sake of maxing out the tax-free accounts, we’ll assume the employee contribution of $3,000 goes toward the Roth 401K. (In reality, the employee has the choice of the regular or Roth 401k. Just make sure the company will match on a contribution to either.) The remaining $16,500 can be contributed by you to the Roth 401k for a total of $19,500. The trade off is that you pay income taxes now on that $19.5k vs. if it were contributed to a regular 401K, you would receive a deduction now, and pay income taxes on it later in retirement when you take it out.

So, hypothetically, that’s $6,000 to a Roth IRA and $19.5K to a Roth 401k.

But it gets better. The combined maximum that you and the employer can put into your 401Ks is $58,000 (for tax year 2021). The difference between $58k and the employee & employer contributions is the amount that can be contributed to the After-tax 401k.

So, this gives the employee flexibility to max out tax-free accounts.

But, for this example, let’s expand and just assume that the employee is also the employer. In other words, he or she owns the business and is a salaried employee of the business as well. To simplify the example, we’ll also assume that the business is co-owned 50/50 with a partner and there are no other employees.

In this case, the company can contribute the $58,000 combined maximum less the $19,500 employee maximum. That’s $38,500 the company can contribute to an aggregate of Pre-tax and After-tax 401K. Since the company has contributed 3% ($3K in this example) to the regular pre-tax 401K, then it has $35,500 left over to contribute. It can do this towards the pre-tax or after-tax 401k.

If we assume that all $35,500 of it goes toward the After-tax 401K, then that is a total of $61,000 going into tax-free investment accounts where growth, gains, dividends, interest, and distributions are all generally tax-free (if you follow the age rules).

Roth 401k:                        $19,500

After-Tax 401k:                 $35,500

Roth IRA:                          $6,000

Total:                                $61,000

The after-tax 401k contribution is taxable now just like the Roth 401k. Then, you can make an in-service distribution to your Roth IRA so that you can invest it the way that you want. If the plan does not allow in-service distributions, then this idea might not be for you. The reason being that if it is left in the After-tax 401k and not rolled into a Roth IRA, then any investment earnings in the After-tax 401k will be taxable in the future.

This all assumes that the plan allows for these types of mechanisms. If you need help designing a plan that includes this, let us know. This strategy is mainly for people who have a lot of money and want to put it towards long term savings in a tax-efficient manner.

One Bridge Wealth Management does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.

If you’d like to learn more, you can reach out to us directly here. We are St. Louis financial advisors and have a virtual financial advisor platform you can read about here. We have clients nationwide.

Interested in learning how to pick a wealth management firm? Learn about it here.

What about how to reduce your capital gains tax? Click here.

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