Are you new to financial independence (FI or FIRE)? Are you steeped in financial independence, but confused about tax optimization?

If so, this is the post for you. This post works on the 80/20 principle: sure, there’s a ton of knowledge, expertise, and hacks out there, but oftentimes 80 percent of the benefit can come from 20 percent of the knowledge. 

But first, a caveat: none of this is advice for your specific situation, but rather, this comprises a list of the top four moves I believe those pursuing financial independence should consider. No blog post (this one included) is a substitute for your own and your advisors analysis and judgement of your own situation.

ONE: Contribute to Your Workplace Retirement Plan Up to the Employer Match

Many, though not all, employer sponsored 401(k)s, 403(b)s, 457s offer some matching of employee contributions. The TSP (for federal government employees) does as well. For example, a 401(k) plan might provide a 25 percent matching contribution up to 6 percent of compensation. Thus, if a plan participant makes $50,000 per year, to get the full match, the employee must put 6 percent of her annual salary, $3,000 total, into the 401(k) in order to get the full employer match, which in this case would be $750 per year (computed as $50,000 times 6% contribution rate times 25% match rate).

In our example above, the employee would be foolish not to contribute up to at least the 6 percent matched contribution rate.

Your top priority in retirement planning is to contribute up to the point of your employer match in your employer retirement account! Money should be contributed there before it is placed anywhere else. An employer match is an instantaneous, guaranteed return on your investment. No one seeking financial independence can afford to pass that up.

Here are some additional considerations.

Vesting

In many plans, the employee is not fully “vested” in the employer match, but only becomes vested after a period of time. Employee contributions are immediately vested, but employer contributions may take some time to vest (i.e., become the property of the employee).

Some plans have “cliff” vesting where the matching contribution is unvested (i.e., not the employee’s money) for three years, at which point the matching contributions (and their earnings) become “fully vested” (i.e., fully the employee’s money).

More common is a graduated vesting schedule. Sometimes it is 20% vested at 2 years and then 20% more each year after, and there are plenty of varieties of graduated vesting.

It is important to understand the vesting rules in your particular plan. That said, a waiting period to vest does not change my view. Contribute to your employer plan at least to the level of the matching contributions! First, the matching level is usually a fairly modest level. If you can’t contribute to that level you may need to re-examine all your expenses to give yourself a decent shot at financial independence and retirement. 

Second, the odds are actually pretty good you will stay with that employer to partially or fully vest and capture some or all of the matching contribution benefits. With the rise of technology enabled virtual work, you might even move and keep your job. So be aware of how your plan vests, but make sure you are contributing to the level required to get the full employer match!

Timing

Many employers match pay period by pay period, instead of only once or twice a year. What that means for you is that you should be careful not to over-contribute to your 401(k) or other employer retirement plan early in the year.

Currently (as of 2021), the employee contribution limit on a 401(k) is $19,500 for those under 50 years old. An employee might have a spouse earning money or otherwise have cash sufficient such that they do not need to take a salary early in the year. Thus, they may consider contributing a very large percentage of their salary to their 401(k) early in the year until they reach the maximum of $19,500, in order to earn more time for tax-deferred growth.

Unfortunately, this strategy will cost employees matching contributions in the later pay periods during the year. In each of the later pay periods, the employee will contribute 0 percent of their salary, meaning there will be nothing for the employer to match. 

Make sure you know how your employer’s plan matches and structure your employee contributions to maximize the employer match you receive.

401(k) Auto-Enrollment

Many employer retirement plans automatically enroll new employees into their 401(k) or other plan. This is to ensure employees don’t lose out on some money simply because they never filled out the paperwork. 

Whenever you join a new employer, you need to learn about the plan and ensure you are contributing at the right level. There are instances where the auto-enrollment contribution percentage is less than the employer matching contribution percentage, so be sure to take action, and if necessary, change your contribution percentage.

Traditional or Roth 

In many plans, the employee does not have a choice – employee contributions are “traditional” deductible contributions. Increasingly, plans are offering the Roth option where the contribution is not deductible today, but the contribution and its growth/earnings are tax-free in the future.

This post addresses the traditional versus Roth issue. But for now, it suffices to say that contributing at the level that receives the full employer match must be your top wealth building priority.

Resource

Your workplace retirement plan should have a PDF document called a “Summary Plan Description” available in your workplace benefits online portal. Reviewing that document will help you figure out the contours of your 401(k) or other workplace retirement plan.

TWO: Establish a Roth IRA

For a primer on Roth IRAs, please read my Ode to the Roth IRA. Roth IRAs, like traditional IRAs are “individual.” You establish one with a financial institution separate from your employer. 

Generally speaking, a Roth IRA gives you tax-free growth, and if done correctly, money withdrawn from a Roth IRA is both tax and penalty free. 

There is no better account to hold in retirement than a Roth IRA. Why not start one today (2021), when (a) federal income tax rates are at historic lows and (b) Roth IRA contributions give you an immediate emergency preparedness benefit.

Roth IRA contributions can be withdrawn tax and penalty free at any time for any reason! The Roth IRA is the only retirement account that offers unfettered, tax-free access to prior contributions. Note, however, in most cases the best Roth IRA strategy is to keep money in the Roth IRA for as long as possible (so it continues to grow tax free!). 

Every working and retired American should ask themselves whether they have a Roth IRA. If they do not have one, they should ask why that is. For those who do not currently have a Roth IRA, now is as good a time as any to consider a Roth IRA contribution (if you qualify), a Backdoor Roth IRA, or a Roth conversion. 

THREE: Contribute to an HSA to the Maximum Allowed If You are Offered a HDHP and the HDHP Works for You

A health savings account is a very powerful saving vehicle. You have access to it if you have a high deductible health plan. To have an HDHP through your employer, you need to determine (i) if your employer offers a HDHP and (ii) whether the HDHP is appropriate medical insurance for you. 

If you do not have employer provided insurance, you may be able to obtain an HDHP in the individual marketplace.

Let’s assume your employer offers an HDHP and you determine it is appropriate for you. At that point, you need to prioritize contributing the maximum to the HSA (second only to receiving the employer match in your 401(k) or other retirement plan and establishing a Roth IRA). You receive an upfront income tax deduction for the money you contribute. If the funds in your HSA are used to pay qualified medical expenses, or are used to reimburse you for qualified medical expenses, the contributions and the earnings/growth are tax-free when paid out of the HSA. This tax-friendly combination means the HSA should be a high priority. 

Here are a few additional considerations:

Payroll Taxes

The HSA has an additional benefit. Contributions made by an employee through payroll deductions are federal payroll tax deductible (unlike contributions to employer retirement plans). To get this additional benefit, you must contribute through an employer payroll deduction. Writing a check to your HSA only creates an income tax deduction.

State Income Taxes

In California and New Jersey, HSAs are treated as taxable accounts. Thus, in these states there are no state income tax deductions for contributions to an HSA. Furthermore, dividends, interest and other realized income and gains generated by HSA assets are subject to state income taxes. While detrimental, the federal income tax and payroll benefits are so powerful that even residents of these states should highly prioritize HSA contributions.

Employer Contributions

Check to see if your employer offers an employer contribution to your HSA. Many do. When the employer does, the employee leaves free money on the table if they do not enroll in the HDHP.

Reimbursements

In most cases, it is advisable to (i) pay current medical costs out of your own pocket (your checking account and other taxable accounts) and (ii) record and track these medical expenses. Leaving the money in the HSA allows it to grow tax-free!

Years later when the money has grown, you can reimburse yourself tax-free from your HSA for the previously incurred costs, as there is no time limit on reimbursements. In most cases, there should be sufficient previous medical expenses that can be reimbursed tax-free from the HSA. Note that only qualified medical expenses incurred after you are first covered by the HDHP are eligible for tax-free reimbursement.

FOUR: Save, Save, Save!!!

My last recommendation is simple: save, save, save! Are there ways to do it in a tax-efficient manner? Absolutely! But the absolute most important consideration is the act of saving and investing itself. Between retirement plans, lack of a payroll tax, and favored dividend and capital gain tax rates, saving and investing are often tax efficient without trying to be. 

More Tax Optimization

Maybe you’ve got the basics down and want to do more tax optimization. Understanding that nothing on this (or any other) blog is advice tailored to your situation, here are some posts that can get your wheels turning regarding tax planning. 

Using your tax return as a springboard to tax planning

Small Business Retirement Plans

Roth Conversions for the Self-Employed

What to Do if You Don’t Qualify for a Backdoor Roth IRA

Conclusion

Here are the top four tax moves I believe FI beginners should consider:

First, contribute enough to your 401(k)/employer plan to get the full match

Second, establish a Roth IRA

Third, max out an HSA

Fourth, Save, Save, Save

Of course, this post is not tailored for any particular taxpayer. Please consult with your own tax advisor(s) regarding your own tax matters.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.