Americans pay Uncle Sam more in taxes than they save and invest for their own future — many, many times more. The average taxpayer loses 29.6% of their income to federal income taxes, according to the Tax Foundation.
For Americans looking to build wealth quickly, slimming their tax bill helps boost their savings rate, which is crucial to reaching financial independence and retiring early (FIRE). It takes a high savings rate to build enough wealth to cover your living expenses with passive and investment income alone.
If you’re interested in reaching financial independence young and living off your investment income, try these strategies for leveraging tax-sheltered accounts to maximize your savings, minimize your tax liability, and ensure you have funds to live on available at every age.
Start With an Independence Plan
Before you can optimize your tax strategy for FIRE, you need a clear vision for your own financial independence. That includes a target age, a target passive income level, and a breakdown of your desired passive income sources.
Age matters because you can’t touch most tax-sheltered retirement accounts until age 59 ½. And your passive income sources matter because most tax-sheltered accounts make it easy to invest in paper assets like stocks and bonds, but difficult or impossible to invest in assets not publicly traded through a brokerage account.
As you craft a financial independence plan, consider how these basic building blocks fit into it.
Stocks have a few broad advantages for your portfolio.
First, they generally offer strong long-term growth. During the past century, the S&P 500 has returned an average of around 10% annually, mostly from price appreciation rather than dividends.
Second, they offer simple diversification. With a single purchase of a mutual fund or ETF, you can buy shares in hundreds or even thousands of companies. That makes it easy to gain broad exposure to the stocks of companies of all sizes, industries, and regions around the world with just a handful of funds.
Stocks also provide liquidity. You can buy or sell them instantaneously.
Finally, they are widely accessible. You can buy and sell stocks easily in almost any tax-sheltered account.
These advantages all combine to make stocks a staple in the portfolio of nearly everyone pursuing FIRE. Stocks also make the perfect starting point for investors, because there’s no barrier to entry.
Real estate forms the other staple investment for many people pursuing FIRE.
While some invest directly by buying properties, there are many ways to invest in real estate to generate income. Some indirect ways to invest in real estate include private notes, crowdfunded real estate loans through Groundfloor, and public or private REITs such as Fundrise and Streitwise.
Regardless of how you invest in real estate, it counterbalances stock investments well for those pursuing FIRE. Its lack of liquidity makes it far more stable than stocks.
Plus, real estate values share little correlation with the stock market, giving added diversification and protection against losing too much in a stock market correction.
Real estate also offers a more income-oriented asset class. Rental properties and funds that own or lend against them generate income immediately and forever. Like stocks, real estate also tends to appreciate over time, but unlike stocks, more of its returns come from income rather than appreciation.
Unfortunately, only publicly traded REITs prove easy to invest in through a tax-sheltered account. The good news? Real estate comes with a range of inherent tax advantages, so you don’t need to use a tax-sheltered account to reap the tax benefits of investing in real estate.
Most investors consider bonds to be lower-risk, lower-return investments, often used to stabilize their portfolio as they approach retirement. Many use bonds to protect against sequence of returns risk — the risk of a market crash in the early years of your retirement.
But many people pursuing FIRE ignore bonds entirely. If you build a portfolio that can support you indefinitely through ongoing real estate income, stock dividends, and a low withdrawal rate, you no longer have to worry about sequence of returns risk because your portfolio doesn’t shrink over time.
Besides, when you retire young, you can always start earning active income again in a pinch. Whether through a side hustle, starting a hobby business, or going back to work full or part time, nothing stops younger adults from supplementing their investment income if they wish.
All of this means people pursuing FIRE can skip the lower returns of bonds if they like, and keep their money in higher-yield investments.
Sample Independence Plan
I hope to reach financial independence within the next five years. Although flexible, my independence plan looks something like this:
- Stock Income: 20% to 30% of my budget. This income includes both dividends and up to a 3.5% withdrawal rate if absolutely necessary.
- Direct Real Estate Income: 30% to 40% of my budget, made up of cash flow from rental properties.
- Indirect Real Estate Income: 10% to 20% of my budget. This largely consists of private REITs and private notes to other real estate investors I know.
- Active “Passion Project” Income: 20% to 30% of my budget. Because I’ll always do something fun and productive with my time, even though it may not pay well.
So, where do tax-sheltered accounts fit into the mix?
Tactics for Tax-Sheltered Accounts for FIRE
Tax-sheltered accounts can help you in several ways on your journey to FIRE.
The following account types prove particularly useful as you build lasting wealth to sustain you for the rest of your life and to leave behind for your children or charities.
You can withdraw contributions from a Roth IRA without paying taxes or penalties, whenever you like.
That makes Roth IRAs extremely flexible as savings and investment vehicles. In “Plan A,” you can leave your contributions invested and untouched, growing and compounding tax-free, to draw on starting at age 59 ½ or later. But the flexibility of Roth IRAs leaves plenty of room for other uses.
To begin with, Roth accounts double as emergency savings vehicles you can tap into any time. In a pinch, you can pull out the money you contributed, tax- and penalty-free.
You can also use your Roth IRA for other major life goals, such as paying for college tuition. The government even allows a special exemption to withdraw up to $10,000 from your Roth IRA’s earnings tax- and penalty-free to buy your first home.
Come for the tax-free retirement income, stay for the flexibility.
Traditional IRA or SEP IRA
The SEP IRA allows you to contribute far more, however — up to 25% of your self-employment income, with a generous cap of $57,000 in 2020. It marks one of the many tax perks of starting your own business and yet another reason to start a side gig.
Deducted contributions reduce your taxable income, freeing money that would otherwise be lost to taxes for you to invest elsewhere. Deductions can also prevent you from spilling into a higher tax bracket and paying a higher tax rate.
But even more importantly, retirement accounts create a cushion to protect your golden years.
I use these and other tax-sheltered retirement accounts to invest in stocks. You can easily automate the investments each month through a robo-advisor, and let them silently grow and compound in the background. Your robo-advisor will even rebalance your portfolio for you automatically, without you having to lift a finger.
Even so, traditional and SEP IRAs prove less useful for pursuing FIRE than Roth IRAs because you can’t touch the money until age 59 ½ without incurring taxes and penalties.
But they can be extremely helpful to have in your later years as a backup plan in case your passive income can’t cover your living expenses or medical costs in your golden years.
Employer-Sponsored Retirement Accounts
Depending on your employer, you might have access to a 401(k), a 403(b), a Thrift Savings Plan (TSP), or a SIMPLE IRA. All of these plans offer higher contribution limits than traditional and Roth IRAs.
Like traditional IRAs, the tax deduction can help save you money on taxes now, which you can then use to invest outside these vehicles. And like IRAs, most employer-sponsored accounts offer a Roth option with the added flexibility to pull out contributions tax- and penalty-free.
(The exception: SIMPLE IRAs don’t allow a Roth option; don’t ask me why.)
But the real value in employer-sponsored retirement plans lies in employer matching contributions. It’s effectively free money — an instant pay raise — just for doing what you should be doing anyway: investing money and building wealth. Employees fortunate enough to receive matching contributions should max them out every year to take advantage of this free money.
Note that the self-employed can create their own solo 401(k) account, and contribute up to $57,000 in 2020. Of course, there’s no free money from employer matching when it all comes out of your own account.
Self-Directed Retirement Plans
All of the retirement accounts listed above share one limitation in common: they only let you invest in publicly traded assets like stocks, bonds, and public REITs. What if you want to invest in rental properties, private notes, crowdfunded real estate, or other alternative investments?
For a fee and some extra headaches, you can set up your own self-directed retirement account. That could come in the form of a self-directed IRA, Roth IRA, or SEP IRA, or you could create a self-directed solo 401(k) if you work for yourself.
The same tax rules and contribution limits apply, but you get to pick and choose any investments you like.
Well, sort of.
If you choose a self-directed custodial IRA, the custodian has to approve your investments before you can fund them. That can delay your investment and cost you time-sensitive investment opportunities. Usually, the custodian charges a fee for each funded investment in your self-directed account, sapping your returns.
Alternatively, you could opt for a checkbook IRA, in which you invest all contributions into an LLC that you own and control. Then you can put the funds toward any investments you like, with no custodial approval or per-transaction fees.But you have to pay the annual fee to maintain an LLC, and if you break the IRS rules with a prohibited transaction, it can trigger fines and disqualify your self-directed account.
Self-employed people with no employees can gain full control with a self-directed solo 401(k), without needing custodian approval for investments.
Although these options all offer you more control and flexibility, they generally cost money to set up and maintain each year. And with greater freedom to invest comes greater opportunity to lose everything with poor investing decisions. Only savvy investors, such as experienced real estate investors, should consider these options.
Health Savings Account
You can deduct contributions in the year you make them, up to $3,550 in 2020 for individuals and $7,100 for families. The money also grows tax-free, and you don’t pay any taxes on withdrawals as long as you put them toward qualifying health care expenses.
Fortunately, “health care expenses” covers a broad range. Beyond doctor’s appointments and hospital bills, qualifying expenses include prescription and over-the-counter drugs, eyeglasses and contact lenses, dentist visits, acupuncture, physical therapy, feminine hygiene products, laser eye surgery, fertility treatments, and dozens of other expenses both directly and indirectly related to health and wellbeing.
Unlike retirement accounts with their 59 1/2 age floor, you can withdraw money from your HSA at any time to cover these expenses. But you don’t have to withdraw the money when you pay for the expense — you can withdraw the money any time in the tax year.
That gives you the flexibility to use your HSA as a tax-advantaged emergency fund. Say you get hit with a $1,000 health bill early in the year, and you pay for it out-of-pocket with your checking account, leaving your HSA untouched to keep compounding tax-free.
Later in the year, if you get hit with medical or other unexpected expenses you can’t cover with your monthly operating budget, you can then choose to withdraw money from your HSA to retroactively cover that $1,000 health bill you previously paid for out of your checking account.
Or you can just use your HSA as a tax-free way to pay for tampons and Tylenol.
Further, HSAs offer a great secondary retirement account. You’ll find plenty of qualifying health expenses in retirement, rest assured.
In the meantime, you can use it as a tax-sheltered emergency fund and health-related spending account.
Limitations of Tax-Sheltered Accounts for FIRE
While tax-sheltered accounts should play a role in your financial independence plan, you can’t live on them exclusively, at least as a younger adult. You also need a taxable brokerage account and other taxable investment vehicles to generate income to live on in the meantime.
As noted throughout, you can’t withdraw money from your traditional IRA, SEP IRA, or employer-sponsored retirement account before age 59 1/2 — at least not without incurring taxes and penalties, or using a special exemption like buying your first home.
The age restriction raises an important question: how do you generate passive income in the meantime?
To create financial independence, you need to build ongoing income that can cover your living expenses starting now, not just after reaching the traditional retirement age. Your tax-sheltered accounts help you build wealth that you can tap into later — and, in the case of Roth IRAs and HSAs, a tax-free emergency fund — but you can’t live on them today.
That means you need income-generating assets held outside of traditional retirement accounts that will provide the funds you need to live comfortably until the funds in your tax-advantaged accounts become accessible penalty-free.
Challenges for Alternative Investments
Unless you use a self-directed retirement account, you can’t directly invest in real estate or other alternative investments. Often, though, these investments offer the best returns, particularly for income yield.
In the absence of an easy way to invest tax-free, you need to pay taxes on the returns you earn. Luckily some alternative investments, such as direct real estate ownership, come with their own tax perks. You can deduct everything from maintenance to mortgage interest, insurance to travel costs.
Consider investing in stocks through your tax-sheltered accounts for long-term growth, and using taxable funds to deal in alternative investments like real estate for immediate income today.
The pursuit of financial independence comes with some surprising benefits, beyond just the option to retire early.
As you get closer to FIRE, you become less dependent on your job. The risk of job loss fades in relevance and urgency; if a recession hits and you lose your job, you won’t starve.
With more wealth and less dependence on your job to pay your family’s bills, you can potentially stop shelling out money for costs like life insurance and long-term disability insurance. That saves you even more money — which you can funnel into investments to reach FIRE even faster.
If you don’t need your job to survive, you can negotiate a higher salary and benefits from a position of strength. All of which puts more money in your pocket to invest with and build wealth. Or, you or your spouse could go part-time or quit entirely to care for your young children and save money on day care or nanny costs to boot.
Life just gets easier the more passive income you have, and the less you need your job to cover your bills.
Tax-sheltered accounts can help you save more money, pay less in taxes, and keep tax-free emergency funds. But to reach financial independence at an early age, the bulk of your investments need to go through taxable accounts and assets.