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Taxes and How to (Legally) Avoid Them

I have decided to write a high level overview I was forced to become
familiar with over the past 3 years:
US government incentivized ways to minimize taxes (as of 2022).

This blog will probably be most helpful to someone who is unfamiliar
with these tax deductions, has the ability to save a couple tens of
thousands a year, and wants to avoid taxes. My imagined demographic
reading this is a tech worker or someone in the financial industries.
The savings per year compound and can have an effect in the low
hundreds of thousands by retirement assuming you start in early 20s.
DISCLAIMER: This is not financial advice and you should do your own
research. Think for yourself.
I personally think these incentives are extremely convoluted and
confusing, but the tax savings are great enough to bare with them.
For example, if one can avoid the marginal tax rate while making
$200k a year, one avoids 32% in federal taxes.

There are 4 accounts that are common and relatively easy to open that
I will discuss: HSA, 401K, IRA, 529

Overview

         HSA Trad. 401K Roth 401K Trad. IRA Roth IRA 529
Pre-Tax                                           state tax
Post-Tax                                          


Trad. is short for Traditional.

  * Pre-Tax: The money going into an account has not been taxed, i.e.
    no income tax
  * Post-Tax: The gains in the account are not taxed when withdrawn
    from the account, i.e. no capital gains
  * Traditional: is pre-tax, is not post-tax
  * Roth: is not pre-tax, is post-tax
  * Investments that are not post-tax free are taxed at and add to an
    individual's income tax rate at the time of withdrawal. If you
    are truly retired, you presumably have no other source of income,
    so these withdrawals would be your only income.

Some things to note:

  * As long as the money is in the tax-advantaged account, any gains
    will be tax free. It is only when you start withdrawing that
    there may be tax/gift implications before attempting.
  * For the retirements accounts (401K, IRA) early withdrawal fees
    before you reach "retirement age" (generally over 60, although
    this will likely increase)
      + There are major exceptions to this like the SEPP

HSA

HSA is short for Health Savings Account. The intended purposes of
this account is actually as a pre-tax account that is only allowed to
spend money on healthcare related items. However, one might be better
served by simply not saving it and instead, investing, because this
is technically the most tax advantaged account that I know of as it
is both pre-tax and post-tax free. Once the owner of the account
reaches age 65, it becomes like a regular retirement account that you
own, and you can withdraw money out of it.

One can only open this if you have an High Deductible Health Plan
(HDHP, as hinted at by the name, a plan with a high deductible as
opposed to a PPO plan). If you are in your 20s with no dependents and
are healthy, then it might be a good idea.
One can calculate the breakeven point between a PPO account and a
HDHP pretty easily, and once you hit the deductible for the HDHP,
these accounts seem to be equivalent. As of 2022, one can only
contribute $3650 for a single person, and double ($7300) for a family
plan.

401K

401Ks are attached to employment for some god-forsaken reason. As of
2022, an employee can contribute $20,500 total between a traditional
and Roth account.

There are 2 ways that I know of to exceed this "limit":

  * One can contribute an additional after-tax (i.e. not pre-tax)
    $40,500 to a traditional 401K
      + The primary reason to do this is the mega-backdoor 401K ,
        which not all plans allow
      + Very few plans actually allow for this, unfortunately
  * Employers can actually contribute and contribute up to $61,000
    into a 401K, but this rarely happens. They will just contribute
    up to the $20.5k limit.



No access until minimum age 55, although there are major easily
Google-able exceptions such as the Substantially Equal Periodic
Payment (SEPP) exception. If/when you leave your employment, you can
(and maybe should) transfer this money into an IRA.

For self-employed people, I would look into a SIMPLE 401K.

IRA

The 2022 IRA max contribution is $6000 between both the traditional
and the roth, so it is not a huge account. IRAs do not allow access
until minimum age 59.5, although there are major easily Google-able
exceptions such as the Substantially Equal Periodic Payment (SEPP)
exception.

There are income limits for the tax benefits that one can directly
receive from contributing from an IRA. As described in the link, with
an income of $140k, one cannot make ANY contribution, at least
directly.
You can avoid all of this difficulty backdoor Roth IRA if you are
hitting these limits. This backdoor is analogous to the mega-backdoor
for the 401K, but is accessible by everyone and the IRS has released
guidance on it.

Another important note is that you can convert pieces of a
traditional IRA into a Roth IRA at any time with the converted amount
counting as income.
When you convert a traditional IRA to a Roth IRA, you will owe taxes
on any money in the traditional IRA that would have been taxed when
you withdrew it. That includes the tax-deductible contributions you
made to the account as well as the tax-deferred earnings that have
built up in it over the years. That money will be taxed as income in
the year you make the conversion.
Ideally, you would make this conversion in a year when you have
little to no income (for example, during a long non-compete or when
starting your own company).

For self-employed people, I would look into a SIMPLE IRA.

529

This is account is only applicable if you have a family member going
to school in the future. This can include unborn children (although
one should pore over the tax implications).

  * Contributions can be state income tax-deductible (e.g. in
    Illinois, contributions lead to a tax reimbursement up to $500)
  * Money can come out tax free at any time as long as you spend it
    on "educational costs"
      + "educational costs" is a very broad category. This can
        include purchases such as laptops.
  * One can contribute 15k before gift tax
  * One can switch beneficiaries tax free up to $70k (double for
    couples) by "front-loading" or "superfunding", although there are
    federal gift tax consequences

Some Additional Helpful Info

There is a common misconception that ETFs are strictly better/cheaper
than mutual funds. Some mutual fund benefits:

  * One does not need to worry about execution (granted, you can only
    execute at EOD)
  * Dividend ReInvestment Programs (DRIPs) automatically reinvest
    your mutual fund dividends
  * One can convert mutual fund shares into ETF shares tax free
    (although not vice-versa)

There is a misconception that mutual funds also always have more
taxes, but firms like Vanguard uses "heartbeat" trades to reduce
taxes on mutual funds (granted, they can't avoid all taxes). Vanguard
has many funds with both mutual fund classes and an ETF class, and
for the purposes of a retirement account that does not have to deal
with these taxes, ETFs and mutual funds are very close.

Vanguard Example Fund

VTSAX is a fund that is "designed to provide investors with exposure
to the entire U.S. equity market". The below image depicts the
different classes of the same fund.
[vanguard]
One can see that if you have "institutional" level money (ie $5M),
the mutual fund is actually cheaper than the ETF, so if you have $5M
invested, you should just do the institutional level. The mutual fund
with the lowest minimum is VTSAX, which has 4 basis points of fees a
year, while the equivalent ETF VTI has 3 basis points of fees a year.
If you have 1 million dollars, this will be an additional $100 of
fees a year, so it will be a trade-off between DRIP and the extra bp
in fees.

One should keep in mind the tax efficiency of the products traded as
well (e.g. bonds are not very tax efficient).

End

This was a broad overview of these retirement accounts. I could not
go over any concept in depth because there is simply too much to
cover, but this should be a good point to start from.

If you see any error in what I said, please email and I will correct
it. Do not email me asking for investment advice, I will not answer.
Thank you Colin R for emailing me corrections.