As CPAs, we understand that most of us think differently about money and finances.
Perhaps, our schooling and daily work gives us a different perspective about the power of compounding interest. Maybe, our natural inclination that led us to the accounting profession leads us to be conservative in our lives.
Often, accountants look to “game the system” by implementing the most cost and tax-efficient strategies in business and personal finance. We cringe at the thought of seeing inefficiencies in others’ personal financial choices.
Here are 5 financial moves to improve your financial position.
1. Don’t make spending and investing decisions based solely on the “tax impacts”
While you should obviously consider the tax implications and seek qualified tax advice when necessary, few instances call for taxes to be the underlying driver for your financial choices.
A tax accountant or attorney should certainly assist you and assess the tax implications big ticket, unusual items such as the sale of a business. However, many people let the tax “benefits” play way too important of a role in their daily choices.
Mortgage Interest Deduction
As an example, many homeowners aim to keep a mortgage around for 30 years simply because of the mortgage interest deduction. However, due to the higher standard deduction from the Tax Cuts and Jobs Act signed by President Trump in 2017, many homeowners find themselves better off taking the standard deduction. This eliminates the need for itemizing at all. Since mortgage interest is as an itemized deduction, you gain no benefit for paying interest.
For some investors, they like the idea of leveraging lower payments and interest rates on their personal residence and investing the extra cash flow at a higher rate of return. Certainly, that’s their prerogative. However, paying thousands (or hundreds of thousands over the life of the loan) in interest just because it is deductible on your tax return makes little financial sense.
As an example, let’s say you are a “high income earner” with a big mortgage balance. Because of the large loan balance, you’ve accumulated interest greater than the standard deduction ($24,400 per couple in 2019). In our example, this means you have a mortgage balance of more than $610,000 at 4% ($24,400 in interest). In this situation, you’re better off itemizing.
Likely, your effective tax rate is around 25%-30% if you can afford such a loan. This means you pay the bank $24,400 in interest. However, you pay $7,320 less in taxes. In effect, you are still out of pocket over $17,000 because you chose to keep the mortgage around. In essence, you just reduced the effective interest rate from 4% to 2.8% ($17,000/$610,000).
The mortgage interest deduction is most certainly a tax deduction lobbied for by the banking and finance industry. However, it does provide a benefit that essentially subsidizes the financing cost of home ownership.
However, getting a tax deduction on your interest payments should not be the main reason you keep a mortgage around.
Capital Gains and Losses
Another area where taxes tend to play an outsized role is in our investment decisions.
While realizing capital gains and losses certainly triggers tax implications, many investors hold off taking profits or selling investments just because they do not want to pay the capital gains.
For the most part, buying and holding your investments over a long period of time will ultimately generate capital gains. As we age and certain higher growth investments outperform, they make up too large of a position in our portfolio. Instead, investors would be prudent to rebalance their portfolios even if it triggers a tax bill.
Make Portfolio Decisions a Priority – NOT Only the Tax Impacts
Many investors worry so much about paying taxes that they do not take profits in their winners even if they believe the long-term prospects have diminished. Alternatively, they may need to shift to a different investment strategy based on their changing risk tolerance.
Instead of locking in gains and paying your tax dues, investors often feel the effects of “golden handcuffs” on their appreciated investments. Remember, the taxes are ultimately unavoidable in your normal brokerage.
You will ultimately pay the capital gains at some point. If you identify more opportune investments, you should consider where your capital will best be invested over the long run. Instead of feeling like you are losing money by paying taxes on your winners, view re-balancing in your portfolio as an ordinary course of business. Simply reinvest the proceeds into other companies with better prospects or that fit your risk tolerance.
Remember, the long-term capital gains tax for most investors is a much lower rate of 15% – just on the appreciated gain. In essence, you still keep 85% of the “free money” that would otherwise be locked up and subject to the market’s daily price fluctuations.
Often, stocks can be very volatile in the short-term. While paying 15% of your gains to the tax man makes every investor cringe, individual stocks often experience price swings of more than 15% in a given year.
If you lock in gains for strategic reasons and pay the tax, you could still come out ahead if the market or stock dips. Further, if you identify opportunities that will outperform your current stock picks, mutual or index funds, investing in better performing assets will more than make up for the tax hit.
Offset Your Gains with Tax Loss Harvesting
Let’s face it – any experienced investor has lost money on certain investments. Unless you take the passive, index investing approach of buying a broad-based S&P 500 fund, your goal is to offset any losing choices with stocks or funds that drastically outperform.
However, at some point you will have poor performers in your portfolio. If you no longer have faith that the company can rebound and believe the prospects for growth and a turnaround are unlikely, you can offset any capital gains by selling your underwater investments.
Instead of paying the taxes on your winners and holding onto a losing investment that you no longer believe will beat the market, you get the best of both worlds. You rid your portfolio of underperformers, re-balance your portfolio by taking profit, and pay no capital gains tax in the process (if your capital loss equals your capital gains). This freed-up capital can then be deployed in better opportunities.
Taxes are Inevitable…
Remember, taxes should not be the sole driver in your personal finance decisions. While the tax impacts should certainly be evaluated in your decision analysis, do not let the fear of triggering a tax liability or gaining a well-intentioned tax benefit keep your from making the best financial decisions.
2. You exchange your freedom for money
While few Americans wake up every morning thrilled to go to their 9-5, we often enter a cycle of working hard at a job we hate to buy things we do not need to impress people we do not even know or like very much.
In essence, we are enslaved to our work so that we can buy experiences and things that help us escape the misery of corporate America.
At the end of the month, we ultimately executed a trade to give our knowledge, time, and freedom for a paycheck and benefits. In exchange, our employer received AND PROFITED from our skills, knowledge, or work.
Working hard by doing something you enjoy and that helps society certainly gives you purpose. However, what if you could pursue your dreams and passions by doing something you love without any financial worries?
We All Have a Finite Amount of Time
As we get older, we only have a certain amount of time on this planet. This may be a morbid reality. Ultimately, we really do not know when our time on Earth will expire.
However, if your goal is to live your best life, you can gain financial independence from your employer. If you hate your job or want to experience freedom and gain your time back, you MUST start seeing your daily financial transactions as an exchange of time and not just money.
Calculate Your Hourly Rate
When we go to make an impulse purchase, many of us simply look to see if we have the money in the bank to cover the cost of what we want. However, we do not really assess how long we have to work to afford the purchase.
Calculating your hourly rate and viewing any purchases by how much TIME you have to work to buy that item can help put into perspective how much you value that good or service.
If you are paid hourly, then the equation is fairly obvious. However, for those of us that are salaried, we often work beyond our standard, 40 hour workweek.
Let’s look at an example for a salaried invidual…
Generally, a standard, 40 hour work week is comprised of 2,080 hours in a year.
Let’s say you make $50,000 per year. This means your base pay is calculated at about $24/hour. However, according to the Bureau of Labor Statistics (BLS), the average American works 44 hours per week. This means the average American works an additional 10% more than they are being paid. In essence, the hourly pay for the average salaried employee that earns $50,000 per year probably works out to around $21.85/hour ($50,000/(2,080*1.1)) before considering taxes.
Assuming a 10% effective federal tax rate for an individual earning $50,000, your take home hourly pay (assuming overtime) is probably closer to $19.45/hour. This is what your time is worth to your employer.
Evaluate purchases based on TIME rather than DOLLARS
Now that you know what your time is worth on paper, you can begin evaluating purchases on the basis of time rather just the dollars and cents.
Let’s say you are at a restaurant trying to decide between a $10 burger and a $30 steak. Buying the burger means you would have to work for 30 minutes to afford the meal. By contrast, you would need to work an hour and a half to purchase the $30 steak. Would you rather have a burger and an hour of your life back or splurge on the steak?
Saving $20 here and there will not make a huge impact for now. However, over decades of saving and investing, you could eventually generate financial freedom from your employer through passive investments.
The biggest benefit of evaluating your purchases on the basis of time rather than money is when you go to make large purchases such as a new vehicle or home.
According to Kelly Blue Book, the average new car price in the United States is over $37,500. If you make $50,000 per year, you could probably either save up this amount of finance the vehicle over several years. However, would this be the best choice? Probably not.
Applying Your TIME and FREEDOM Factor
When you evaluate it on dollar terms, you probably think, “I can easily afford the payments.” However, let’s apply a time and freedom factor rather than just the monetary aspect.
Assuming no financing charges and fees, taxes or registration costs, at $19.45/hour, you would need to work 1,928 hours to buy the average new vehicle. In essence, you would need to work every single day for nearly 1 year just to pay for that vehicle you drive. Since you probably have other expenses such as food and rent, it would probably take you 3 years or longer of working to pay for the average new car purchase. Now, you can easily assess from the TIME and FREEDOM perspective of whether buying that new car is worth sitting in your cubicle all day for nearly a year.
While you should certainly enjoy life and buy the steak every now and then, the purpose of these examples is to simply help you evaluate the relative value of purchases in terms of time rather than just money.
If buying that new car and working an entire year to make the purchase is worth trading a year of your life, then go for it. However, more than likely, assessing your purchases in terms of time and freedom will help put your financial decisions into perspective based on what you truly value.
3. Do NOT waste money on depreciating assets
All too often in American society, we are plagued by the consumerism mentality. However, in time, the newness and shininess fades. We are left holding payments on goods that steadily decrease in value.
There is nothing wrong with driving a nice car if you can afford the purchase or buying things that you like or want in moderation. However, building wealth becomes hard if everything you spend money on eventually becomes worth NOTHING.
Many times, hard-working families reach their 50s and 60s having earned in excess of a million dollars in the working lives with nothing to show for their work. Instead, they find themselves looking good and wearing designer brands or driving new vehicles but deeply indebted and enslaved to their spending habits.
Buying New or Expensive Vehicles
The single largest purchase that the average American makes that depreciates in value is their vehicle.
Unless you live in a metropolitan area with easily-accessible public transit, we all need a mode of transportation to get us from Point A to Point B. However, over time, vehicles depreciate in value until they are sold substantially below their original purchase price or are worthless and sold for scrap.
Continually purchasing a new vehicle, taking a 30% hit in depreciation in year 1, and repeating the process every few years WILL take a toll on your financial situation.
The Average New Car Payment is $530/month
While you may be able to afford the average monthly payment of $530/month on a new vehicle, you must consider the total opportunity cost of buying a new car (as well as the TIME and FREEDOM factor that we previously discussed).
Not only will you be out $530 in cash flow every month on a depreciating asset, the opportunity cost of having car payments your entire life can be financially devastating.
Let’s assume your 25 and just expect having a car payment your entire life until you pass away at age 80. You have determined that you can simply budget for this luxury each month.
If you had instead invested $530 per month over the course of your life at the historic average returns of the S&P 500 (10%), your opportunity cost would be nearly $12 million.
While I certainly understand there will be periods of time where you will not have a car payment, this back of the envelope calculation illustrates the impact of maintaining payments. The opportunity cost of investing that money could generate incredible wealth.
4. Do not be afraid to invest
Besides not budgeting and having enough left over to invest, one of the most popular reasons cited for not investing is due to fear. In fact, a survey conducted by Ally Financial found that 61% of adults find the stock market “scary or intimidating.”
After you have set up your budget and found a few hundred extra bucks to begin socking away for a secure financial future, you can conquer your fear of investing with a little bit of education.
What is the S&P 500 (or “Market”)?
One of the best places to start learning about investing is by understanding what “the Market” means in the investing world. The S&P 500 is an index that tracks the ~500 largest U.S. companies.
With each dollar invested in the index, investors’ money is divided up among some of the most well-known and established companies in the world. This list includes Amazon, General Motors, Apple, Boeing, Nike, and other large capitalization, publicly-traded companies.
What are the benefits of purchasing an S&P 500 index fund?
The benefit of purchasing an index fund that tracks the S&P 500 is that you instantly achieve “diversification” at a very low cost (generally .02%-.08%). When you own shares in the index, you own a tiny fraction in the hundreds of companies that the index tracks.
When one company is down on their luck, another company typically offsets the decline. This offers stability to your portfolio. Similarly, if and when a few companies in the index inevitably go bankrupt, you probably will not even notice the decline in value (unless it is one of the behemoth companies such as Amazon or Apple).
Because of the low cost, instant diversification, and simplicity in setting up automated contributions, buying a broad-based index fund is one of the best places for most new investors to start.
S&P 500 Performance
As an added benefit of diversification, an S&P 500 index fund gives you exposure to virtually every aspect of the American economy.
As our domestic companies grow and expand through innovation, expansion into overseas markets, or GDP/economic growth, the companies make more sales and earn more income. This income can either be reinvested in the business for growth or put back into your pocket through either share buybacks or cash dividends.
The fear of losing money is one of the biggest excuses that keeps potential investors sidelined.
Often, the critics of investing will cite that the overall market is down once every 3 to 4 years. However, if you have a time horizon that is more than 5 years and are willing to ride out any market volatility and continue to invest through downturns, the risk of losing principle is greatly diminished.
As the chart above shows, the S&P 500 earns a positive return substantially more often that experiencing down years. In fact, since inception in 1926, the S&P 500 has averaged annual returns of 10% per year.
What do 10% returns mean for your financial situation?
At first, a 10% annual return may not mean that much to you. After all, this correlates to an average return of less than 1% per month.
If you had $10,000 in your 401(k) or Roth IRA, at a 10% return, you would only have netted $1,000 in year 1. However, over time, your earnings also contribute to the overall return which results in “compounding interest.” At an average return of 10% per year, your initial principle would have doubled in about 7 years. This is purely due to the power of compounding.
Let’s look at a more detailed example:
Let’s assume we have a married, 25-year old couple earning the median U.S. household income of $60,000. Most financial planners recommend contributing 15% of your gross pay for retirement. In this case, our couple would contribute $9,000 per year into their 401(k) or IRAs.
If they contributed $9,000 every year (which assumes they NEVER receive a pay increase) until they are both 65, this couple would have nearly $4 MILLION at age 65. Over the course of their lives, they only contributed $360,000 ($9,000 x 40 years). This means that virtually all of the invested balance ($3.6 million/$4 million) is due to compounded interest.
Continue Your Research Journey
If you are furthering your investment education through reading this blog and other resources, you can continue developing your knowledge base through research.
Consider expanding your knowledge base through reading some of these iconic books on investing: Best Books to Enhance Your Investing IQ.
For an in depth look at getting over your investing fears, read this article: Overcoming Your Fear of Investing: 3 Ways to Get Over Your Investing Worries
5. Invest for your goals tax efficiently
Remember, taxes should NOT be the primary reason for making investment or spending divisions. However, our government includes laws and regulations aimed at helping citizens save for important expenses through the IRS Tax Code. Using tax-favored vehicles that run in parallel to your primary savings goal (such as retirement, college, or healthcare) will help you achieve your goals faster.
Tax-efficient Portfolio Planning
Planning and investing for your goals does not have to be difficult and stressful.
If you have no desire to do your own research to figure out the different tax-advantaged accounts, you can always seek professional help from a fee-only, fiduciary financial adviser that has your best interest at heart.
However, by doing your own research, you can easily identify the best accounts to save for most big expenses you’ll encounter in life.
A Few Types of Tax-Advantaged Accounts
- Retirement: Traditional 401(k)/403(b)/IRA
- Retirement: Roth IRA 401(k)/(403(b)/IRA
- Healthcare: Health Savings Account
- College: 529 Savings Plan/Coverdell ESA
Retirement Savings
Scraping together a few extra dimes to put away for retirement can be difficult for most families.
However, every single person with an earned income should look for ways in their budget to generate enough excess to begin putting away something for their future needs when they reach retirement age. As you progress in your career, experts recommend putting at least 15% of your gross annual income into tax-advantaged accounts to ensure your investments will replace your earned income.
While many of us know the basics of retirement savings and there are countless resources available, here is a brief description of the tax advantages that Traditional and Roth accounts provide for individuals saving for retirement.
Traditional 401(k)s/403(b)s/IRAs
Through Traditional accounts, investors defer the taxes they owe into the future.
Why is deferring taxes a good thing? Well, the tax advantages of deferring are twofold:
1. You receive an income tax deduction on your contributions today
By contributing to a Traditional account, the IRS allows you to deduct your contributions on your current tax return. In essence, this lowers your taxable income by your contribution amount. Effectively, the government subsidizes your retirement investing by your personal income tax rate.
Example: If your effective tax rate is 20% and you contribute $10,000 into a Traditional account, you can deduct $10,000 on your tax return. This deduction effectively saves you $2,000 in taxes that you would have otherwise paid to the federal government.
2. Taxes owed are deferred until you take distributions in retirement
Remember that tax deduction you got each year as you made contributions? Well, eventually, the IRS would like their dues.
However, even though you still eventually will need to pay your taxes, you still come out ahead because of “time value of money.” The bedrock principle states that “a dollar today is worth more than a dollar in the future.”
The tax savings you received in the year of contribution can be invested and compound over time. You can now put this money to other uses such as saving for your child’s college or healthcare costs.
Further, because your money is invested in a tax-deferred Traditional account, as your money grows through dividends and capital gains, the government does not tax you along the way. This allows your money to grow unimpeded.
However, when you finally do reach retirement age and can begin taking distributions (59 1/2), the withdrawals will be treated as earned income (just like your salary).
Hopefully, in retirement, your tax rate will be lower since you have stopped working. Then, you would have received a tax deduction in years when you were working (and had a higher tax rate) and made withdrawals at lower tax rates (in retirement).
Roth 401(k)s/403(b)s/IRAs
Similar to Traditional accounts, Roth accounts provide a tax-advantaged way to save for retirement.
While you will not receive a tax deduction on your current income tax return, your entire balance grows completely tax-free. Since 95%+ of your ending balance in retirement will be made up of capital gains and dividends (and not your own contributions), receiving tax-free distributions means you keep more of your money.
In effect, by contributing to a Roth account, you will be subconsciously contributing “more,” and you will have 100% of your ending balance available to spend as you please (versus paying taxes). For this reason, opening a Roth account can save you hundreds of thousands or even millions in taxes.
Looking for the details on retirement accounts? Read more on Traditional vs. Roth Accounts HERE.
Healthcare Savings Account (HSA)
If you have qualified High-Deductible Healthcare Plan (HDHP), a Healthcare Savings Account (HSA) offers a lucrative way to save for inevitable healthcare costs.
More than likely the premiums on your HDHP would be much lower than your traditional PPO or HMO plan. This is because as the name implies, your deductible is much higher before your insurance kicks in to cover costs. However, once your reach your out of pocket max, insurance covers 100% of the cost which could save you money on big ticket healthcare costs (such as surgeries or chronic illnesses).
With HDHPs, there are three primary drivers of the plan’s economics:
- Monthly Premiums
- Deductible Amount
- Maximum Out of Pocket Limit
If you are healthier than average or have extreme, chronic illnesses, a HDHP with an HSA could end up saving you money in the long run – especially, considering the tax efficiencies of HSAs.
Run the numbers for yourself to see if a HDHP offered by your employer is more economical.
What is a HSA?
Now that you have a brief understanding on the background of HDHPs, it’s time to learn about why HSAs can be a lucrative means to save for healthcare expenses.
HSAs are efficient in three ways:
- Contributions are tax deductible
- Contributions can be invested and grow tax-deferred
- Withdrawals made for qualified healthcare expenses are tax-free
Tax-deductible Contributions
Just like Traditional retirement accounts, contributions made to your HSA are deductible on your current year income taxes.
In essence, the federal government subsidizes your healthcare costs by allowing you to exclude this income from your federal tax return.
While the limits are lower than retirement accounts, contributing to an HSA can save you hundreds of dollars on your taxes each year you contribute.
As an added benefit, your contributions can be invested in the stock market, grow, and compound over your life.
Tax-Deferred Growth
Similar to your Traditional retirement accounts, your invested balance grows tax-deferred.
As you investments pay dividends or realizes capital gains, the IRS does not require you to pay taxes like you would in an ordinary brokerage account.
This means that the investment in your HSA is shielded from taxes and can compound over decades or until you need to access the money for your inevitable healthcare expenses.
Tax-Free Distributions
When the time comes to pay for doctors visits, medication, or other qualified healthcare expenses, you can pull out money from your HSA. Most plans provide a debit card that is linked directly to your account.
If you have invested the money in index funds, you can simply sell some of the investment and use that money to reimburse yourself for the qualified costs. Even though some (or most) of the money may be from market gains and dividends, you will NOT owe taxes on this amount. This feature makes HSAs extremely lucrative in combination with the lower premiums HDHPs offer.
Looking for details on HSAs? Read more on HSAs HERE.
Saving for College: 529 Savings Plans and Coverdell Education Savings Accounts (ESAs)
We all know that college is outrageously expensive. With over $1.5 trillion in student loan debt, America’s next generation is crippled by the debt burden they undertook on for college.
Unfortunately, little can be done from a prospective student’s point of view other than plan, save, invest, and work during their college years if necessary.
While the debate for how to best provide affordable public college will rage on, you can prepare your household for the inevitable cost of college by beginning to save today.
529 College Savings Plan and Coverdell ESAs
Through a 529 College Savings Plan and a Coverdell Educational Savings Account (ESA), you can begin investing thousands of dollars today and pay for college with the tax-free capital gains – just like your HSA pays for medical expenses.
However, unlike the HSA, you will not receive a tax deduction for your contributions. Instead, your money grows tax-deferred and is ultimately tax-free when used for qualified college expenses – including room and board, tuition and fees, internet, and many other ancillary expenses.
With the average total cost of college hovering around $100,000, forking over $25,000 per year out of your annual cash flow may not be feasible. However, by investing, you can put away small increments over time and allow the market do the heavy lifting.
In fact, if you opened a 529 Account or a Coverdell ESA at birth, after 18 years of contributing $167 at the historic market returns of 10%, you would have $100,000 to pay for your child’s college expenses. Based on this analysis, you would have only contributed around $36,000. The bulk of the $100,000 balance is made up of capital gains and dividends.
While Coverdell ESAs generally offer more flexibility as far as investment selection, the limits on these accounts are much lower ($2,000 for 2019).
Looking for more details on 529 Plans and ESAs? Read more HERE.