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In 2016, my taxable income plummeted. However, my net worth went up considerably. How does this happen? Tax-efficient investing.
Tax-Efficient Investing--Initial Steps
- Contribute to a Roth or Traditional IRA every year. (See info on the back-door Roth below.)
- Contribute to a Health Savings Account every year.
- Contribute to SEP-IRA when possible.
- If you have money left over, explore the Mega-Back Door Roth IRA option. You can usually get well over an extra $10,000 per year into a Roth through this strategy. (Just google it.)
- Sell stocks that are under-performing (reap capital losses).
- Ensure that assets throwing off income are in tax-deferred accounts while those that have minimal dividend or other income are outside of tax-deferred accounts.
- Recognize that assets that simply appreciate don't generate any taxes at all unless you sell them.
Max Out the Roth IRA!
Many beginning investors are reluctant to put too much money in tax-advantaged accounts. They worry that they will be cut off from the funds in case of an emergency or if they retire early.
However, funds that you initially contribute (the principal) to a Roth IRA are always available for withdrawal without a penalty. So it pays to be more aggressive and put the funds in a Roth. Then, if you do need the funds early, you can access the principal (not any gains) tax free. Yes, the paperwork would be a bit annoying if you had to pull out funds, but in reality it probably isn't that likely you will ever actually need to access the funds anyway (assuming you have built your emergency fund and a buffer).
So I encourage you to always max out the Roth if you can. If your income is too high to contribute straight to a Roth, you can always use the back door Roth as a technique.
Tax-efficient investing is a great example of how smart decision-making can pay off over time. At the end of 30 years of making these types of decisions, if you have $2 million in tax-deferred or sheltered accounts, it will save you thousands upon thousands of dollars annually in taxes. It's a big part of attaining financial freedom.