In an earlier post, I mentioned that navigating the realities of today’s environment requires understanding taxes and overcoming your fear of investing. After getting a handle on your debt, the next step in your journey to financial independence is to use your resources (net savings) in the most tax-efficient manner to generate the maximum returns for yourself. In this post and next one, I am going to show you how to craft your specific tax-efficient investment strategy.
Why the big fuss on taxes? Because taxes have a huge impact on your investment returns. As you will appreciate in future posts, pivoting yourself in the right direction from the start is critical to your long-term success. You might have often heard several people say that they consider nothing more frustrating than dealing with taxes. In fact, a lot of people simply pay an accountant to file taxes on their behalf. However, if you are serious about financial independence, then this a monster which you will have to learn how to slay rather than taking the easy route and outsourcing it.
Tax System – Get To Know The Plumbing
US and Canada both have a progressive taxation system. People with higher income are charged a higher tax rate. Most people understand the concept well. For most people, taxation is nothing more than a line item on their paystub, a burden that the government has imposed upon them.
However, what most people often do not understand well is that the government has also created ways to legally reduce your tax burden. The two ways to do this are:
1. Tax deferment – taking a portion of your income and choosing not to pay income taxes on it that year. You contribute a portion of your income to a tax-deferred account. If you earn $40K in one year and defer $5K, your taxable income is $35K. The $5K that you deferred goes into a separate account where it can grow tax-free. However, if you withdraw the money, your taxable income increases by the same amount.
2. Tax sheltering – putting money in a place where taxes are no longer applicable. You contribute a set amount to a tax-sheltered account where it can grow tax-free. Even if you withdraw the money down the road, you will not be subject to any taxes.
Regional Differences
You might have noticed that I have used the term “tax-deferred” and “tax-sheltered” account. So what are these accounts and how can you utilize them? Depending whether you are in US and Canada, different terminology is used to describe these accounts but the underlying concept is identical.
USA
Without a doubt, the system of tax-deferred and tax-sheltered accounts in the US is a dog’s breakfast! If you are new to it, it can quite intimidating. I will try to keep is as simple as possible. Tax-deferred retirement accounts can either be employer-sponsored or individual.
The four different types of employer-sponsored tax-deferred accounts are:
401(k) – private, for-profit company (most common)
403(b) – non-profits
457 – state government employees
TSP – federal government employees/armed forces
The government puts flat limits, regardless of income, on the maximum amounts you are allowed to contribute to each account. People aged 50 and over are also provided additional room. For 2023, the limit is $22,500 and the catch-up contribution limit is $7,500 for those aged 50 and older. Do check out the IRS website on what the limits are for each year.
What Else?
The other type of individual tax-deferred account is the traditional IRA. With this account, you can get access to retirement benefits even if your employer does not offer a 401(k). The only type of tax-sheltered account, where the deductions are not tax-deductible, is the Roth IRA. Between the two different types of accounts, you are only allowed to contribute a maximum of $6500 (as of year 2023) or $7500 if you are aged 50 or older (as of year 2023).
Lets Make It Even Harder
Another thing to note is the IRS imposes limits on what you can contribute overall between these six different accounts. For example, in 2023, a single person who has access to an employer-sponsored 401(k) and makes more than $73k in a year cannot contribute anything to a traditional IRA. If that same person happens to be making more than $138K in a year, then he or she cannot contribute anything to a Roth IRA either (however, as you will see later, there are ways around it). Also, do keep note that the tax-deferred and tax-sheltered accounts in the US have a “use it or lose it” policy. If you are eligible and do not fund these accounts in a given year, then your contribution rooms will NOT carry forward and you will lose it forever.
Canada
In Canada, the system is way much simpler. The only tax-deferred account is the RRSP and the tax-sheltered account is the TFSA. For the RRSP, unlike the US, the maximum contribution limit is based on 18% of your previous year’s earned income up-to a pre-defined ceiling which is set by the government. This formula applies for people who do not have access to a employer-sponsored defined benefit pension plan. For 2023, that ceiling is $30,780. For those having access to a corporate pension plan, the annual contribution limit will be reduced.
As for the TFSA, it is a straight-up limit similar to the Roth IRA. For 2023, it is $6500. Besides these restrictions, the CRA does not impose any limits of any sort. See how elegant it is?
Not only that, the unused contribution rooms for the RRSP and TFSA accounts carry forward indefinitely into the future. So if you cannot fund it in any given year, then you can always do so later. Pretty neat!
TFSAs – Some Finer Points
Also, specifically for TFSAs, there are two main aspects that you need to know:
1. The TFSA will permanently increase in size if the investments in it go up. This concept is best illustrated by a simple example. Suppose that you make the maximum contribution to your TFSA in 2023 for the amount of $6500 in January and invest it in a stock. Lets assume that stock appreciates in value and you decide to sell in December for a gain of $3000. This results in $9500 in your TFSA account which you then withdraw in full. In 2024, you will then be able to contribute the full $9500 in addition to the 2023 room. When you experience a capital gain in your TFSA, you permanently increase its size! However, remember that a sharp knife cuts both ways. If you experience a capital loss, you permanently decrease its size.
2. When you make a TFSA withdrawal, you are then eligible to re-contribute the same amount the following year. The withdrawal amount does NOT get added back in the same year. This rule is not well-understood by most people and can unknowingly result in excessive contributions, which are then subject to penalties.
Your Tax-Efficient Investment Strategy
Once you understand the basic plumbing of how the tax structure works, the next step is to develop your tax-efficient investment strategy. The tax-deferred and tax-sheltered accounts together are what is known as your “tax-free swimming pool”. In the context of financial independence, it is extremely important. Not only you save taxes upfront but any growth in that pool is tax-free. You must target to fill up your tax-free pool as much as possible, if not the maximum.
So, how do you do this? Filling the pool right up to the brim might be a walk in a park for someone making $150K a year. But what about someone who only makes $55K a year? How should he or she prioritize? Well, there are two rules you must follow:
1. Don’t let your employer off the hook – if your company offers a matching 401(k)/RRSP program, make sure you contribute the highest possible amount to maximize the free money you will get. Otherwise, you are giving your employer a free pass.
2. Know the maximum income tax bracket you fall under – For 2023, a single person in the US is subjected to a 10% federal tax for income up-to $11,000 and a 37% federal tax for income beyond $578,126 or more (with five other tax brackets at 12%, 22%, 24%, 32% and 35% in between). For tax-deferred accounts, you gain the maximum benefit if you contribute at the highest rate and withdraw in the future at a lower rate. For Canadians, the federal income tax brackets are different compared to the ones in the US but the underlying concept is exactly the same.
Which Account Should be Filled First?
The account you should fund first depends on which tax bracket you are in. This concept is critical to developing your tax-efficient investment strategy. If you have modest income, then it makes sense to fund your Roth IRA/TFSA first. It is not much value-added to contribute at a 10% or 12% (15% and 20.5% for Canadians) as the gains from tax savings are marginal. At higher income levels, you will move into higher tax brackets. It then makes sense to fund your 401(k)/traditional IRA/RRSP first. In the following year, you can claim the deductions when you file your taxes and direct the tax-free funds to the Roth IRA/TFSA (which can then grow tax-free as well).
Of course, at higher income levels, you might be in an envious position where you can fund both accounts to the maximum and still have leftovers directed to a taxable investment account.
Double Contribute?
Find out if you can double contribute – depending on your company, you may qualify for two employer-sponsored retirement accounts. Public school teachers, health care workers and other non-profit and public sector employees may be able to open a 403(b) and a 457. It is not openly advertised so do take the time to find out. You may get pleasantly surprised!
Sorry Canadians, there is no such provision up north!
Legal Loopholes For High Income Earners in US
There is no doubt that the US tax system, compared to Canada, is much more accommodating to people in the high-income range. If you happen to be a high-income earner in the US, there are two legal loopholes you can utilize to maximize your tax-free swimming pool:
1. Back-door Roth IRA – this is a neat way to side-step the IRS policy of not allowing a single person making more than $138K (as of 2023) to contribute to a Roth IRA. You can contribute to a non-deductible traditional IRA and then ask your financial institution to convert it to a Roth IRA. Here is a link to an excellent article on how to make that happen.
2. Rich Person Roth – this is another way for high-income earners to use a life insurance policy with a cash value to grow money tax-free and generate tax-free income. It’s like a Roth IRA with no income and contribution limits! However, there are certain pitfalls that you must be aware of. Here is a link to an article on how a Rich Person Roth works and whether it is a right fit for you or not.
In The End
That’s about it. Developing a tax-efficient investment strategy depends on knowing the intricacies of the tax laws and then tailoring it to your income level. I do realise that everyone’s individual situation is different and there is a lot of questions you might have. Also, all the information I provided here is current at the time of writing. The tax laws can, and most often do, change in the future which may invalidate some of the advice I put forward.
Yours truly,
Rizwan.