Maximize how much money you earn and keep after taxes

“In this world, nothing is certain except for death and taxes.” ― Benjamin Franklin*

Welcome to this latest post in my journey to build financial literacy for young adults. Today’s topic is focused on how to optimize your after-tax investment returns.

Benjamin Franklin’s famous quote certainly holds true as you will have to pay taxes on any of your investment earnings which can have a large impact on how much you actually get to keep and enjoy. Fortunately, the government provides opportunities to minimize taxes through tax-advantaged investment accounts. These accounts are particularly good deals for younger investors who currently have lower incomes. Tax-advantaged accounts are generally retirement accounts whose goal is to get you started on and stay the course for saving for retirement and that’s what I’m going to focus on in today’s post. There also are tax-advantaged accounts for other purposes such as medical expenditures or funding education. Those are also effective ways to minimize your taxes, but are more complicated so I will defer discussing those for another day.

There are two major types of tax-advantaged retirement accounts:

• Provided by your employer: 401(k)
• Set up by individuals: IRA
• To make things more complicated, there are also two versions of each of the above accounts, the traditional IRA or 401(k) or the Roth version

The original gist of both types of accounts was to provide ways to reduce the impact of taxes. This is how traditional IRAs and 401(k)s work:

• You can invest money up to a certain limits ($6K for IRAs in 2021 and $19.5K for 401(k)s) with pre-tax dollars. Pre-tax in this context means that the money you invest into these accounts is not taxed by the federal and state governments. This allows you to invest more money as each dollar you put into these accounts costs you less than one dollar of post-tax income
• Any investment earnings are not taxed as long as you don’t withdraw monies from the account. When you invest, you pay taxes on any income such as dividends or capital gains, even if you reinvest those monies. In tax-advantaged accounts, you don’t pay taxes on income until you withdraw money from the accounts. Now, this doesn’t mean you won’t ever pay taxes on the earnings. You are just deferring taxes to a time (retirement) when your expected income will be lower which should coincide with your being in a lower tax rate band
• 401(k) employer accounts are further advantaged in that most employers will match a portion of what you invest with additional monies that they contribute. While each employer is different, a very common match is for the employer to add an extra 0.5% of your income for each 1% that you contribute to your 401(k), subject to a maximum of 3%. This is “free” additional money which you should contribute enough to get. Now, I put the word free in quotes as you should actually view a 401(k) match as part of your income. Just make sure not to leave it on the table by contributing a lower amount to your 401(k) than needed to get the maximum match

There are some limitations on these accounts if you are a high-income individual, but for young adults who are just starting their careers you shouldn’t need to worry about breaching income limits. However, it is worth educating yourself on these limits but the tax benefits are definitely worth the time to do so.

For those of you below specific incomes ($140K Adjusted Gross Income for single taxpayers in 2021 and $208K for married filing jointly**) who are willing to pay a little more in taxes today with the goal of even further reducing taxes in the future, the Roth IRA is a great option. Similarly for those of you whose employer offers a Roth 401(k). These accounts are very similar to their traditional cousins, but have these differences:

• Your contributions to these accounts are done with post-tax dollars. So, the initial cost to invest in these accounts is higher as each dollar you invest in these accounts costs you one dollar of post-tax income
• However, once you’ve invested in these accounts and as long as you’ve met certain requirements (for example, meet the minimum retirement age or at least had a Roth account for 5+ years for certain uses), any earnings from the account are tax free. Depending on your investment returns and the length of time you’ve invested in these accounts, the earnings themselves can be multiples of what you put into the accounts, so the tax savings can be very large

While everyone’s tax situation and preferences are different and only you can determine what works best for your circumstances, my general advice to younger folks is to contribute to Roth versions of these accounts up to the limits that you are able to based on your income.

Hope you find these tax-advantaged accounts to be a valuable pillar as you build out your investment plan – they are certainly an important tool to help you maximize the share of your investment returns that you get to keep and enjoy. Remember the wise words of Robert Kiyosaki, author of the Rich Dad books:

“It’s not how much money you make, but how much money you keep, how hard it works for you, and how many generations you keep it for.” ― Robert Kiyosaki***

Thank you again for joining me on my journey to build financial literacy for young adults. If you have any questions on today’s post of if there are any topics you’re interested in my writing about, please let me know. I can be reached at [email protected].

* Blackalliance.org: https://blackalliance.org/death-taxes-quote/

** https://www.irs.gov/retirement-plans/amount-of-roth-ira-contributions-that-you-can-make-for-2021

*** Featured in: Robert T. Kiyosaki Quotes, Quotes About Money