For first generation US immigrants like us, it takes a while for us to get to know about the tax savings plans here in USA.
By the time we learn and implement those plans, half of our life in US would have been already gone.
So to learn those quickly, this episode is a shortcut.
What we are going to see is, how we can save maximum tax and invest...
And in which order should we invest to achieve that...
Lets say that our friend Appu is earning 120K.
Now he is in 22% tax bracket. He is a subscriber of our channel as well.
After watching the "Building Wealth" series, he realized the importance of saving when we are young.
So he is planning to invest 40K every year in an Index fund.
How can he invest this 40K for maximum growth?
He is going to invest in an Index fund anyways. But which account would give him maximum savings?
To achieve maximum savings, we should invest in tax advantaged accounts like 401K, IRA etc.
We should not be investing in a brokerage account that has no tax benefits before taking advantage of these tax advantaged accounts.
Remember the Power of Compounding. The tax difference that looks small now, would grow many folds after many years.
So we should always max out tax advantaged accounts first before investing in a brokerage account that has no tax advantage.
There are many tax advantaged accounts like 401K, IRA, HSA and 529.
Which one among these would give maximum return for Appu?
For that, we should know the investment priorities.
Lets see what kind of tax advantage we have with each of these accounts first.
Money contributed in "Regular 401K" is tax deductible
But when we take out, we have to pay tax as regular income.
In ROTH 401K, we would have contributed after paying the tax. But it grows tax free.
No tax in it when we take the money out.
IRA is like 401K.
Tax deductible on contribution. But it will be considered as regular income when we withdraw.
ROTH IRA is like ROTH 401K.
We would have contributed after paying the tax. But when we withdraw, there is no tax.
Both contribution and earnings.
HSA - this one is a special account.
The contributed amount is tax deductible. The withdrawal - as long as it is used for qualified healthcare expenses - it is tax free as well.
And for this reason, HSA is the best among all other tax advantaged accounts.
529 - we contribute after paying tax. But the withdrawal is tax free if used for qualified education expenses.
Like ROTH IRA. But the restriction is that it can be used only for education purposes without penalty.
Lets check out in which order should we contribute money in these accounts to take maximum advantage.
The first in the priority list is - Making a 401K contribution to get the matching contribution from our employer.
There is no reason to explain Why. It is free money.
Can we miss when someone pays us to eat a cake? Definitely not.
We have already covered about 401K and ROTH 401K in our channel.
If you have not watched it yet, please watch that first.
Many employers match 401K contribution.
Lets say that Appu's employer is matching his contribution 100% upto 5% of his contribution.
So if Appu contributes $5,000 in his 401K, his employer would contribute another $5,000 to match that contribution.
Totally $10,000 would have been contributed to his 401K.
100% return right there.
So as first step, always contribute as much as your employer matching your contribution to your 401K.
It is no brainer. There is nothing to even think about.
For 401K contribution, we do not have pay both federal and state tax.
So Appu is contributing $5,000 to his 401K.
Employer is matching that with another $5,000.
Now his savings is $10,000.
Out of $120K income, $5,000 has gone for 401K. So now the taxable income left is $115K.
Next priority is to maximize HSA contribution.
If your employer offer a High Deductible Health Care plan, then they would definitely offer HSA as well.
The way HSA works is, we can contribute to HSA every year.
No federal and state tax for that contribution.
We can use that money for qualified healthcare expenses.
This is very simple and straight forward right?
But there are some special qualities in this HSA.
If we use it strategically, we could multifold its benefits.
It is not like a FSA account.
The contributed money does not have to be used in the same year like in a FSA.
We also have option to invest this money in an Index fund.
Wait a minute. I can contribute money to HSA every year, invest that money in an Index fund and use it for healthcare expenses after retirement? Definitely.
Wouldn't 10% growth for 30 years would have grown many folds? You bet.
If we do that, then we get triple tax advantage.
First advantage - no tax for contributed money.
Second advantage - No tax for withdrawal as well as long as it is used for qualified healthcare expenses.
Third advantage - No capital gains tax on earnings as well.
That is why HSA is a superior retirement savings account than a 401K.
Many maximize their HSA upto their contribution limit.
This year that limit is $7,200 per family.
But they will not claim for healthcare expenses.
They will just save the receipts for those expenses. They can be claimed any time.
They will invest the contributed amount in an Index fund and let it grow.
When they change the employer, they will roll over this money into their personal HSA and let it grow even further.
They will use this for their healthcare expenses after retirement.
After 65 years, if we withdraw the money for non-qualified expenses, it will be considered like a 401K withdrawal.
That is we have to pay the tax for the withdrawal amount.
So at best, HSA account has triple tax advantage.
At worst, it has the same tax advantage as in a 401K.
That is why we should maximize our HSA account before maximizing our 401K.
Minimal investor has explained this in more detail. The link is in description. Check it out.
This works out well for people who are planning on retiring in USA.
But if you are in H1 and if you are not sure if you are going to be in USA after retirement, then may be you can skip this step.
Our Appu is maximizing this. His savings is now $17,200.
Now the taxable income is $115,000 - $7,200 = $107,800.
Next priority is to maximize IRA accounts.
Maximize Traditional IRA or ROTH IRA depending on your income level.
If you are not eligible for both, then you can do a Backdoor ROTH IRA.
We have already covered about IRAs in this channel.
If you have not watched it yet, please watch that first.
Tax benefit wise, this is same as 401K.
Both have federal and state tax benefit.
But the investment options in IRA's are better.
It does not have restrictions of investing only in the offered funds as in 401K.
For that flexibility and control, we should maximize the IRA before maximizing 401K.
Our Appu is contributing $6,000 in his ROTH IRA. Another $6,000 in his wife's ROTH IRA.
Now his savings is $29,200. Taxable income is the same $107,800.
Because we would have already paid tax for ROTH IRA contribution. Its the growth that is tax free in ROTH IRA.
Next priority is to max out 401K.
As of now, we can contribute up to $19,500 in 401K.
We will not have that many invest options in 401K as in IRA. But most of them have Index funds.
Our Appu has saved $24,200 so far out of his goal of $40,000.
In this step, he is contributing $14,500 to 401K and maxing it out.
So in total, $5,000 contributed in first step + $14,500 in this step, he would have contributed a total of $19,500 to his 401K.
Now his total savings is $43,700. His contribution - $38,700. Employer contribution - $5,000.
Now his taxable income is $93,300.
Only after doing all this, we should look into contributing in 529 for kids education.
We will cover the 529 more in detail in another episode.
But in short, there is no federal tax benefit for the money contributed in 529.
There is state tax benefit, but not for all states.
Even though the contributed money does not have a tax benefit, it grows tax free.
But we can use it only for qualified education purposes.
When used for educational purposes, it is like a ROTH IRA.
But if we withdraw for other purposes, we have to pay the capital gains tax for the earnings and also a penalty of 10% on earnings.
Also 529 does not have the wide investment options in IRA's. Its very limited.
Because of these disadvantages, many do not use 529.
But if we choose a 529 plan from the right state and invest, this is a good tax advantaged account.
Our Appu is investing the $1300 left from his savings plan in 529.
Thinking that this is kids education - so lets contribute more - he is contributing $5,000 in 529.
So far Appu has saved $48,700. His contribution is $43,700.
Only after doing all these, we should look into investing in a brokerage account.
Because brokerage account has neither federal tax benefit nor state tax benefit.
We have already seen the amount of difference a tax advantaged account could make in final returns in our 401K episode.
So for investment, keep brokerage as the last option.
Now we have reduced Appu's taxable income from $120K to $93,300.
Now lets check out Appu's year end income and savings.
Appu's wife is house wife. Has 2 kids.
He has 5% state tax.
After standard deduction and child credit, he will have only around $65,000 as final taxable income.
For a 12% federal tax and a 5% state tax for that amount, he would end up paying around $11,000 for tax.
So total income after tax - $114,000. Savings - $48,700.
Savings rate is almost 43%.
If he saves at this rate, he will attain his financial independence in 17 years. After that - Woohooo!!
All the numbers you saw in this episode is in the google sheet link in description. Use it if you want.
The sooner we know this priority list, it is better for us in USA.
If you think, this could be helpful for any of your friends, please share.
We will soon meet again in another episode. Thank You.