By Michael Kitces, as posted on 7/4/18 – Executive Summary – The Federal government has long incentivized saving for retirement and other financial goals by offering some combination of three types of tax preferences: tax deductibility (on contributions), tax deferral (on growth), and tax-free distributions. As long as the requirements are met, various types of accounts – traditional to Roth IRAs, and annuities to 529 plans to Health Savings Accounts – enjoy at least one tax preference, often two, and sometimes all three.
For most households, these tax-preferenced accounts simply help to encourage (and tax-subsidize) savings towards various goals, and cash-flow-constrained households allocate based on whichever goal has the greatest priority. Yet for a subset of more affluent households, where there’s “enough” to cover the essential goals, suddenly a wider range of choices emerges: how best to maximize the value of various tax-preferenced accounts where it’s feasible to contribute to several different types at the same time?
Fortunately, the fact that not all accounts have the exact same type of tax treatment means there is effectively a hierarchy of the most preferential accounts to save into first (up to the dollar/contribution limits), after which the next dollars go to the slightly less favorable accounts, and so on down the line… from triple-tax-preferenced accounts such as the Health Savings Account (tax-deductible on contribution, tax-deferred on investment growth, and tax-free at distribution for qualified medical expenses expenses), to double tax-preferenced accounts such as traditional and Roth-style IRAs, to single tax-preferenced accounts such as a non-qualified deferred annuity (which is tax-deferred only). Which in turn must be balanced against even “traditional” investment strategies of simply buying and holding in a taxable account… which itself effectively defers taxes, thanks to the fact that long-term capital gains are only taxed upon liquidation.
Notably, many of the tax preferences do come with trade-offs (such as penalties for early distribution, and rules about how the funds can be spent), but for high-income earners, those limitations simply mean it will be necessary to coordinate amongst the various tax-preferenced savings accounts at the time of liquidation (and aren’t a reason to not use them in the first place).
Of course, there is still the foundational tier of savings to provide an emergency fund (and perhaps funds to promote job mobility and business startup expenses as well, which may be particularly appealing for higher income individuals), but the key point is to acknowledge that there is a hierarchy of tax-preferenced accounts – ranging from triple-tax-preferenced accounts to accounts with no tax preferences – and high-income earners can better limit their tax liabilities and maximize their growth by adhering to this hierarchy!
To read the full article by Michael Kitces please click here.