How to Have a Tax-Efficient Investment Strategy

Transcript

The first thing that is interesting is the bucket strategy. We often talk about diversifying investments between different asset classes, and we should also diversify where we’re paying taxes from in retirement. If we have money in after-tax assets (like brokerage accounts or individual or joint accounts), tax-deferred assets (like 401ks or IRAs), and tax-free assets (like Roth accounts), we can legally manipulate the tax code. There’s a perfect illustration that shows how each of these tax buckets grow.

In the private Facebook group for the Financial Order of Operations course, someone asked if they should focus on the tax-deferred bucket since they were already doing their Roth IRA and Roth 401k without an employer match. If they fall into that category, they might only have two of those buckets (tax-deferred and tax-free). If we can do tax-deferred contributions now and get a current year tax benefit, we should do it, because we don’t know what the future holds.

We should try to build up three of the buckets (or two or as many as make sense in our situation) so that when we get to retirement in an unknown tax environment, we have maximum flexibility. Even if we were focusing all our saving efforts on tax-free assets, we would still likely end up with some tax-deferred assets just because of the employer match.

The question that folks always end up asking is, “How do I decide between Roth and pre-tax?” It’s all driven by age. The younger we are, the more we want to take advantage of tax-free growth, so that’s where the Roth assets come in. But there will come a crossover moment where we’re in a very high income tax situation, or maybe we’re having a crazy great income year. On those years, we might want to deliberately focus on tax-deferred assets.