Executive Summary
- Taxes are inherently complicated. But if you understand a few basic principles, tax efficient investing becomes relatively straightforward.
- Tax efficient investing is ultimately about using legal strategies and incentives to minimize your lifetime tax bill by doing three things: (1) categorizing income so that it receives the most favorable possible tax treatment; (2) deferring taxes due on income; and (3) when possible, eliminating taxes entirely.
- Critically, investors must understand that there is always a cost to tax strategies. This cost may not be “explicit” and able to be quantified, but it exists nevertheless and must be taken into consideration.
In the previous chapter, we covered the four types of income taxes.
The bad news is that, by default, every dollar of income that you make will be subject to one, two, or three of these taxes. The impact of this, as we covered in the first chapter, is absolutely devastating.
The good news is that there are numerous tools at your disposal that can help you to defer or eliminate these taxes, thereby enhancing your portfolio returns.
A quick note…
Unfortunately for investors, there are dozens of different taxes that are levied. There is a sales tax, gas tax, property tax, hotel taxes, airline taxes — some cities even charge an “entertainment tax.” This chapter will focus narrowly on income taxes: the taxes that must be paid as a result of earning money.
Also, this chapter will focus on federal taxes and steer clear of state taxes. While the impact of state taxes definitely should not be ignored, the sheer volume of different regulations makes it difficult to address thoroughly.
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Principle #1: Remember Your Goal
The goal of a tax efficient investor is to use proven, legal, safe strategies to minimize his lifetime tax bill and, therefore, maximize his bottom line returns.
Tax efficient investing does NOT involve taking excessive risk and using legally dubious strategies. There are plenty of gray areas in the tax code, but most of the “playbook” consists of proven and approved techniques.
In fact, many of these strategies take advantage of incentives created by the government. In other words, Uncle Sam wants you to take advantage of these opportunities. That’s why incentives are created: to incentivize certain behavior.
Another important word in the paragraph above is “lifetime.” Tax efficient investing is NOT about looking at your tax return in April and trying to figure out how to maximize your refund. It is more forward looking in nature, and is focused on minimizing the amount of taxes you will pay over the rest of your life (and even beyond).
Principle #2: Best Times to Pay Taxes
Isaac Newton had Three Laws of Motion.
I have Two Laws of Investing. The first is…
The two best times to pay taxes are: later, and never.
Cheesy, I know. But it’s a critically important concept.
Almost every tax savings strategy accomplishes one or both of these two objectives: allowing you to pay taxes later, or never.
It’s really that simple.
If you can legally pay your taxes later – without racking up penalties or interest – you’ll create wealth.
And if you can legally avoid paying taxes altogether, that’s even better.
You may be thinking that this is too good to be true, and that there’s no way the IRS will let you do either of these things.
That’s generally true. In many instances, there’s no way to delay your tax bill or eliminate it altogether.
But there are plenty of instances where it’s not only allowed, but encouraged.
To understand how to follow this “First Law,” it helps to know about the Three Buckets.
The Three Buckets
Most investors will invest in a number of different asset classes: stocks and bonds are the biggest, but you may also hold real estate, gold, or other “alternative” assets.
And they’ll generally use three types of account types – or “buckets” – to hold these investments.
Some of these accounts are better than others at allowing you to adhere to the First Law – paying taxes later, or never (or, sometimes, both!).
Obviously your investment returns will depend on the performance of the stocks, bonds and alternatives that you invest in. But they also depend on the fees and taxes you pay.
And that depends in large part on the Bucket.
Below is a summary of the Three Buckets. Bookmark this page, because you may want to refer back to this:
| Bucket | Examples | Tax Free Contributions | Tax Free Growth | Tax Free Withdrawals |
|---|---|---|---|---|
| Taxable | Brokerage Account | No | No | No |
| Tax Deferred | Traditional IRA, 401(k) | Yes | Yes | No |
| Tax Free | Roth IRA | No | Yes | Yes |
Bucket #1: Taxable Brokerage Accounts
Most investments are held in Bucket #1, the taxable brokerage account.
This isn’t a particularly tax efficient place to hold your investments, for three reasons.
First, the only way to fund this account is with after-tax dollars.
That means that you first have to pay taxes on your income. Then, you can use whatever is left over to buy stocks and bonds in your brokerage account.
Second is the “tax drag.” When these stocks and bonds pay you dividends – as they hopefully will – you’re hit with another tax bill.
This creates what is known as a “tax drag.”
Let’s say you have $100,000 in your account at the beginning of the year. At the end of the year, your account has grown to $103,000 and you’ve also received $3,000 in dividends.
That equates to a 6% return.
But we haven’t yet factored in taxes. If your dividends are taxable at 20%, you owe $600 in taxes. All of a sudden, your net return is just 5.4%.
Finally, you’ll owe capital gains taxes when you sell any stocks and bonds that have appreciated in value.
Continuing the example above, let’s say you wanted to liquidate this account to pay for living expenses. You realized a $3,000 capital gain – the increase from $100,000 to $103,00 – that is taxable.
At a 20% capital gains rate, you owe another $600 in taxes. That brings your net return down to just 4.8% (Calculated as [($3,000 + $103,000 – $600 – $600) / $100,000]).
Bucket #2: Tax Deferred Accounts
Tax deferred accounts, Bucket #2, allow you to pay some taxes later, and some taxes never. They check both boxes of the First Law.
Tax accounts, such as a 401(k) or Traditional IRA, can be funded with pre-tax dollars. In other words, contributions to these accounts are tax deductible.
Or, in plain English, funding these accounts lowers your tax liability today – by allowing you to pay taxes later.
Tax Deferred Example: The 401(k)
Here’s a very simplified example.
Let’s say you make $150,000 a year as a single taxpayer. In 2023, you’d owe about $26,076 in federal income taxes (we’ll ignore state taxes for the sake of simplicity), leaving you with $123,924 after taxes.
If you were to defer $22,500 – the maximum allowed for 2023 – into a 401(k), your taxable income is reduced by that amount. Your taxable income is now $127,500 (your $150,000 salary less the $22,500 of your salary that you deferred) and you owe just $20,676 in taxes this year
That’s $5,400 less than you would have otherwise.
Congratulations! You’ve successfully taken advantage of a part of the tax code that allows you to pay taxes later (more on this in a minute).
There’s another nice feature of tax deferred accounts.
The $22,500 goes into your 401(k), where you can use it to buy stocks and bonds. When those stocks and bonds pay you a dividend, you won’t owe any taxes. When you sell appreciated stocks and bonds, you won’t owe any capital gains taxes.
Congratulations! You’ve successfully taken advantage of a part of the tax code that allows you to pay certain dividend and capital gains taxes never.
But tax deferred accounts also make a deal with the devil – or, more accurately, a deal with the IRS.
You’ve only deferred the income taxes due on your earnings. When you withdraw from this account in the future, you’ll be taxed at ordinary income rates – as if the withdrawals were a salary from your employer.
I call this a deal with the devil, because we don’t know what tax rates will be in the future.
You’re somewhat at the mercy of the IRS; if interest rates are higher in the future, you’ll have to pay taxes on your withdrawals at that higher rate.
Even with this uncertainty, tax deferred accounts are much better than the alternative.
That would be Bucket #1, where you pay taxes on your income and taxes on your capital gains.
Bucket #3: Tax Free Accounts
Bucket #3 is the tax free account.
Much like Bucket #1, the taxable brokerage account, tax free accounts are generally funded with after-tax dollars.
In other words, your contributions to these accounts are not tax deductible. They don’t reduce your taxable income this year.
Once you get money into these accounts, however, they are incredible.
Just like Bucket #2, the tax deferred account, you won’t owe any taxes on dividends or capital gains in this account.
You get to reinvest all of your dividends, and you don’t have to pay capital gains taxes.
The real kicker is the ability to do tax free withdrawals. When you sell stocks in your tax free account and withdraw the cash in retirement, you won’t owe taxes.
It doesn’t matter if the stock has increased by 10x. Or 100x.
Or 1,000x.
The capital gains taxes are the same…
Zero.
Zilch.
Nada.
Principle #3: The Magic of Time
Now that you know all about the Three Buckets, it’s time to move on to the Second Law of Investing.
I didn’t actually make this one up. I copied it from Albert Einstein:
Compound returns are the eighth wonder of the world.
When you are able to invest over a long time horizon – decades, not years – incredible things can happen even if your annual returns don’t seem all that impressive.
Consider a few examples of compounding returns:
Between 1976 and 2006, Berkshire Hathaway stock grew at an annual rate of about 27%.
That’s a pretty good annual return. But when you realize that return over a long period of time – 30 years in this example – the results become mind boggling.
An initial investment of $10,000 in Berkshire in 1976 had grown to about $13 million in 2006.
There’s a second part of Einstein’s quote about compounded returns: “He who understands it earns it. He who doesn’t, pays it.”
Credit cards illustrate the flip side of the compound return equation.
Consider someone with a $10,000 balance on a credit card that charges 20% annual interest. They commit to paying it down over five years.
Over that time period, total payments will equal about $16,000. Just $10,000 of that is the original balance; the remaining $6,000 is interest.
1 + 2 = 55,000
The real beauty of tax efficient investing occurs when you combine Law #1 with Law #2.
When you use strategies that allow you to pay taxes later or never and let these strategies play out over a long period of time… the results are pretty staggering.
Example #1: The Backdoor Roth
Let’s go back to Bill and Ted.
They both have $6,500 that they’d like to set aside for retirement. They expect to invest in assets that will return 8% a year, and retirement is 25 years away.
Bill puts his money into a taxable brokerage account and lets it grow.
When he sells this stock in retirement, after all taxes are paid he’s left with $33,757. Not bad!
But, alas, he’s one-upped yet again by Ted.
Ted knows about the Backdoor Roth IRA. Using this maneuver, he puts his $6,500 into a Roth IRA.
When he sells in retirement, it’s grown to $44,515 – and he owes $0 taxes.
That’s an additional $10,758… which is great. But it gets better.
Ted’s wife can also do a Backdoor Roth – and all of a sudden they’ve generated an additional $21,516.
Not a bad payoff for maybe an hour of work.
Example #2: The Child IRA
Bill and Ted both have 13-year old sons: Little Billy and Little Teddy.
Both Billy and Teddy made $3,000 over the summer mowing lawns, delivering newspapers, and babysitting.
Billy’s dad wants to give Billy a lesson on saving for retirement, so he sets him up with a brokerage account to invest the money.
Over the next 50 years, Billy’s investment returns 8% a year prior to the tax drag. When he retires at age 63, his $3,000 has grown to $106,000 – a testament to Law #2.
Billy owes 20% of the capital gains in taxes, leaving him with $86,000.
Ted knows about the Child IRA and he sets one up for Teddy.
His summer savings grow at 8% for the next 50 years, without any tax drag.
And because he set up his Child IRA as a Roth, Teddy gets to withdraw $141,000 tax free in retirement.
Maybe he’ll use some of the extra $55,000 he made to take Billy out to a nice lunch.
Principle #4: Take Ownership
A lot of financial advisors are, for lack of a better word, idiots.
There are of course some very talented advisors who do amazing work for their clients.
The reality is that being a financial advisor is a fallback career for many finance majors. It’s often Plan C after becoming an investment banker or a fund manager. When those higher paying options don’t pan out, many end up as financial advisors.
That doesn’t make them bad people (though there are plenty of those in the wealth management industry as well).
There’s a similar phenomenon with accountants. For anyone who struggled in math class, the idea of being a professional number cruncher is often mind boggling. So they tend to be in awe of CPAs, assuming that they are half man / half supercomputer capable of solving all manners of complex challenges.
Again, the reality is more disappointing. A lot of CPAs are basically operating slightly advanced versions of QuickBooks (if you don’t believe me, do a search for “ProSeries tax software”).
It’s also been my experience that most CPAs are capable of answering very specific questions, but generally incapable of thinking creatively or proactively making you money.
For example, many CPAs will be able to confirm that you’re executing a Backdoor Roth IRA correctly.
But don’t hold your breath waiting for them to come to you with ideas for generating wealth through greater tax efficiency. They have no incentive to do so (and, thus, they won’t).
Think of your accountant more like the scoreboard operator, and less like the coach. He can tally up your performance at the end of the year, and tell you how you did. But he’s probably not going to be proactively giving you advice on how to minimize your tax liability.
OPM
OPM – which stands for Other People’s Money – explains a lot about the world.
In short, nobody is going to be as vigilant with your money as you. No matter how well you align incentives and reward their performance, your portfolio is still OPM to them.
This dynamic plays out in almost every aspect of life. It explains why many politicians are happy to roll out expensive new programs with questionable or non-existent benefits: they’re funded with OPM.
It explains the difference in behavior of “trust fund babies” who were gifted OPM compared to self-made entrepreneurs who earned their fortunes through blood, sweat, and tears.
It explains why owners of a company often have different attitudes towards expensive perks than employees.
It explains why many companies attempt to align incentives of top performers by granting stock options or other equity-based compensation.
Wisdom From 1776
This isn’t a new concept. In fact, it’s at least as old as the U.S. itself. Adam Smith recognized it in 1776:
“Managers… of other people’s money rather than of their own… cannot well be expected [to] watch over it with the same anxious vigilance with which [they would] watch over their own.”
Smith was pointing out what he saw as glaring and obvious flaws with the incentive structure of the time.
His general observation still applies nearly 250 years later – as does his rather pessimistic conclusion:
“Negligence and profusion, therefore, must always prevail.”
When it comes to your portfolio, you have two options. The easiest is to let others run the show. This is the easiest way. It involves the least amount of thought and effort.
The alternative is to take ownership. This doesn’t mean that you need to micro manage every aspect of your financial life. I certainly don’t prepare my own tax returns – I pay a CPA to do that, for a variety of reasons.
But I take a lot of pride in being an “active client” of his. I ask a lot of questions. I propose tax savings ideas all the time. Typically, I’ll tell him exactly what I want to do and ask him to essentially “check my work” and make sure I’m not overlooking anything.
Reading this guide is a huge step in the right direction. If you’ve made it this far, you’re clearly committed to developing a deeper understanding of tax efficient investing.
If you make it through the remaining chapters, you’ll feel a deeper understanding. You’ll have armed yourself with the knowledge necessary to take a more active role.
Principle #5: DIFN
This is going to be tough to hear. But you’ve probably figured out by now that I’m not one to hold back or sugarcoat anything.
You screwed up. You’ve undoubtedly missed chances to maximize the value of your tax advantaged accounts.
Unfortunately, it gets worse (before it gets better).
There’s nothing you can do to make up the deficit. Those ships have sailed. If you didn’t execute a Roth IRA in 2018, you’ll never be able to do so. If you didn’t max out your 401(k) in 2005, you don’t get a redo.
I had this realization several years ago – that I’d never be able to go back to 1997, and put the $5,000 I made bagging groceries into a Roth IRA. That the window to make a “stealth IRA” contribution to my HSA in 2012 had been sealed shit, never to reopen.
So I know exactly how this realization feels. It stings. If you’re like me you kicked yourself and then cursed everyone who failed to teach you these lessons.
That’s fine. Take a few moments to be upset, at yourself or at anyone else.
Then let it go.
Because what really matters is what you do next. What really matters is that you get motivated to not let any more of these opportunities pass you by. Because most tax savings strategies are perishable.
They’re available only for a limited period of time, and then they are gone forever.
DIFN is another concept that I didn’t invent. It comes from something I read in 2007:
When it comes to building your business, there are 4 words that should be echoing in your mind throughout the day; they are “Do it F***ing Now.”
The Default Option Sucks
Unfortunately, the default route is a very inefficient one – at least from a tax perspective.
The default is to ignore your IRA, and hand over a big chunk of your retirement savings to Uncle Sam.
The default is to ignore your 529 plan, and rack up another big tax bill when it comes time to pay for college.
The default is to just buy a target retirement date fund, and not worry about which assets are more efficient than others.
Your default is to ignore all the tax savings opportunities available to you, because they require a little bit of work.
You’ve got to take action.
It’s important that you recognize this weakness of human beings, and commit to overcoming it.
Don’t put off funding a 529 or executing a backdoor Roth.
Don’t wait until next year to set up a Solo 401(k) for your business.
Don’t leave your 1031 exchange or QOF investment until the last minute.
This is especially important because many of the most impactful tax saving strategies are perishable. They are windows that are open for a limited amount of time, and then slam shut.
There’s a maximum amount that you’re allowed to contribute each year to your 401(k), IRA, HSA, and 529.
The positive way to look at these funds is as “renewable” tax savings opportunities. Each year, you can shelter more of your money from taxes.
But there’s a flip side of that coin as well: once the deadline has passed, it’s gone for good.
When you sell real estate and realize a gain, the 180 day clock on your 1031 exchange starts ticking immediately… and it doesn’t stop because you’re on vacation or busy with life.
When you pass away after a full and satisfying life, it won’t matter that you were planning on getting around to setting up that trust one of these days. If your “estate plan” is an aspiration and not an executed document, your heirs will be left to deal with the bill that comes due from the IRS.
It’s important that you have a sense of urgency about this, because the cost of complacency is too darn high.
DFIN.
Do it f***ing now.
Principle #6: Weigh the Costs
It is critical to understand that there are costs associated with virtually any tax saving strategy.
These are typically NOT explicit or direct costs. They don’t require you to make a payment or up front investment. But they are costs nevertheless, and as such should be taken into consideration.
Cost #1: Time
Many tax savings strategies take a bit of time to implement. There is a value to your time, meaning that there is a cost to these strategies. Again, this may not be an “out-of-pocket” cost since you never have to cut a check or send a wire, but it is a real cost nevertheless.
Cost #2: Complexity
Most tax strategies will add some degree of complexity to your life. This may be in the form of additional recordkeeping or additional tax forms. Again, the time that you must dedicate to these tasks has a value. Additionally, you may experience a mental cost associated with the extra complexity in your life.
Cost #3: (Lack Of) Liquidity
Many tax strategies impose restrictions on your capital. This may be a time-based restriction; you typically cannot access money in your IRA, for example, until you are at least 59 1/2 years old. Or it may be a use-based restriction; 529 funds, for example, must be used for certain educational expenses in order to avoid taxes and penalties.
The value that you place on this liquidity will depend of course on your circumstances. If you have sufficient assets in “unrestricted” accounts, you may be happy to pay this “cost” in exchange for the tax benefits.
Key Takeaways
This chapter included more “foundational knowledge” that is important for any investor interested in minimizing their lifetime tax bill to understand.
If these six principles make sense to you, you’re now armed with a solid framework for diving into the weeds and beginning to apply them to your own portfolio.
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Table of Contents
This page is part of our Ultimate Guide To Tax Efficient Investing. Follow the links below to read through the entire guide. Or, click here to download the full PDF version.
- Chapter 1: Why Taxes Matter (The One Big Myth) — The impact of taxes on your portfolio.
- Chapter 2: The Four (Yes, Four) Types Of Income Taxes — Understanding the “default” tax treatment your income receives.
- Chapter 3: Guiding Principles (And An “Aha Moment”) — Six rules of thumb that will make your life easier.
- Chapter 4: The 401(k) (Your Tax Free “Workhorse”) — My the 401(k) is the most powerful wealth creation account for most investors.
- Chapter 5: IRA Strategy (And the Value of Flexibility) — How to use IRAs optimally to minimize your lifetime tax liability.
- Chapter 6: Asset Location (And the Greatest Investment Ever Made) — Why it matters where you hold your bonds.