This note talks about tax advantaged schemes in the US I employee and my current thinking into why and how much I should be investing with these accounts.

HSA

Not taxed going in, not taxed pulling money out; restrictions apply.

If you have a high deductible insurance plan, you can use the Health Savings Account as an investment vehicle. Many HSA accounts like from Fidelity let you invest without fees into any stocks, ETFs or funds, offering a lot of freedom to make investment decisions.

Pretax contributions

It has a contribution limit of $3,550 a year. This is your pretax money, which means this amount will be deducted from your taxable income.

Tax free withdrawals

You can withdraw money from this account as long as the they are for HSA eligible medical expenses. Receipts are required. You may withdraw for other reasons by paying a 20% penalty.

To take the maximum advantage of this account, save your medical receipts and reimburse them all in one go when you really need the money, hopefully much later in life. Till then, let the money grow in this account tax free.

Comments

The biggest disadvantage of this account is that you need to keep track of your medical receipts yourself. A teammate from my old job literally maintained a shoe-box to put these in. Some HSA accounts now let you upload receipts for safe-keeping too and you can apply these expenses as and when you need the money. This is great as it takes most of the overhead out.

Links:

Backdoor Roth IRA

Taxed going in, no tax going out;

Traditional IRA accounts are used to invest for retirement with pretax money. Unfortunately, this has an income limitation of $124,000 for investing. This can be overcome by a well known loophole in the tax code, hence the name “Backdoor” Roth IRA.

The idea is to put money you’ve already paid tax on in the Traditional IRA and move that into a Roth IRA after a few days. This is necessary because a ‘transfer’ needs to be recorded.

Post tax contribution

You can contribute up to $6000 a year towards this, which is the limit for 2020. Make sure you move the money quickly, as you will owe taxes on any gains while it’s in the Traditional IRA account.

Tax free withdrawals

You can withdraw the invested amount after 5 years or if you are older than 59.5 years. Withdrawing gains before retirement come with a 10% penalty. You never pay taxes on this amount as you’ve already paid taxes on this.

Comments

Roth are popular since the money can sit in the account and grow tax free. Being able to withdraw a part of the account in 5 years is not too bad, compared to 401k.

Links:

Employee sponsored plans

401k

No tax going in, tax pulling money out; Employer may match a portion of contributions

A popular scheme if provided by the employer to reduce one’s taxable income. Many companies also match your contribution by a percentage and up to a certain percentage of your salary. This is basically free money into your 401k account on top of whatever you’ve elected to save.

Pretax contributions

The limit for 2020 on 401k contribution is $19,500. See Restrictions section for more details. Employer contributions are on top of this amount.

Taxed during withdrawals

You can withdraw money upon retirement. The money is taxed as regular income tax, so it’s like getting paid. If you need to withdraw the money before you are 59.5 years old, there’s a 10% penalty plus income tax on the amount.

Comments

Instead of withdrawing from the 401k, you can take a loan against your account. You will have to pay your account back regularly and in 5 years.

Mega-backdoor Roth

Taxed going in, no tax going out; Should be supported by employer

This employs another tax code loophole, uses ‘after-tax’ 401k investments and converts them to a 401k Roth plan. Even though it’s a backdoor, it has been codified into the law, so much so that Fidelity even offers automatic conversion from the after-tax account to Roth (called daily in-plan conversion)

Post-tax contributions

My employer has a limit of $27,500 on post tax contributions to 401k Roth, so that nobody ever exceeds the total 401k contribution limits.

Tax-free withdrawals

As with all taxed contributions, withdrawals are tax free. So the money can grow tax free in this account. You can only withdraw the money after retirement at 59.5 years and after holding the account for more than 5 years.

Comments

The biggest downside of this is that it is employer dependent, so you may or may not be able to do this.

Links:

Restriction

401k contributions are limited, but there are no specific limits on employer’s contribution or after-tax contributions. Instead, there’s a maximum total limit of $57,000 on the sum total of these three.

My thoughts

I’m thankful that I have a job in tech and get paid a very competitive salary. My intuition going forward is that since the salaries will potentially remain competitive, I can take home less than what I would have today and put that difference in these tax advantaged accounts.

  • I would have invested this share of my salary anyway, so might as well get a favorable tax treatment by investing via the accounts mentioned above.
  • A hidden advantage is that because of these, my take home salary is much smaller, which keeps my spending in check.
  • The concern for locking in your money and paying a penalty if you need it sooner is real. That’s when taking a good look at your expected expenses in the future as well as what percentage of your pay should go into these accounts is important. You don’t need to commit the full limits and balance your pros and cons.

You want to start as early as possible as each of these accounts have a yearly maximum allowed.

I love the Roth accounts because I can invest in safe investments which don’t get special tax treatments like the long term capital gains tax. For more information, see Investing, Taxes and Tax Advantaged Accounts.

“I may need the money”

The biggest disadvantage to these funds is the penalty of early withdrawal. Although some of these accounts let you take a loan against the balance, they are restrictive in general. My thinking towards this has been to take a look at how much money I would get in hand and if I absolutely need all of that for an upcoming big expense. Anything besides what I may need for that particular expense can go into these tax advantaged accounts.

These are retirement investment accounts and therefore, by definition promote long term investing and prevent early withdrawals. The tax advantages are given to promote this behavior.

HSA

By getting an account with someone that lets you upload receipts for future reimbursement, the pain to manage an HSA account is almost out. My current employer does not support it, but paying no tax on investments is great and I highly recommend using this before the others.

Backdoor Roth IRA

I’ve started investing with this account ever since I got to know about it. I am risking not being able to withdraw the principle amount for 5 years, but in return I save tax on investments that I would have made anyway with that money.

401k

I am currently investing to get my employer’s match so I don’t leave any free money on the table. I am considering investing more in the future if I can build up enough savings.

Mega-backdoor Roth

I am maximizing the $27,500 I can invest via this vehicle. This limit is set by my current employer to keep 401k investments under $57,000 at all times. My reasoning for using this strategy include:

  • Not all employers offer this, so I want to maximize the benefit while I work at a place that does.
  • The strategy again is that I would have potentially invested this amount anyway, might as well do it by saving tax. I do lose the opportunity to withdraw this money.