The List: Tax-advantaged accounts — tax saving, wealth multipliers.
The ‘don’t blame me’ blurb: I am not a financial advisor, portfolio manager, or accountant. This is not tax or investment advice; it’s information to get you going. Please consult your trusty professional and do your due diligence. Carry-on!
More in our series of ‘More for us, less for you, IRS!’
Below is a list of tax-advantaged accounts we can use as freelancers. Learn the ways of the force, I mean accounts. As freelancers, investing is our ultimate side hustle! This is a list you can come back to over time.
Grab something caffeinated and read on. No, Aperol does not have caffeine in it.
Why do these accounts matter?
This comprehensive list of tax-advantaged accounts can save us hundreds of thousands of dollars of taxes and help grow our investments over time. At first, they can be a little confusing, but stick with it and get comfortable with the terminology. None of us ever stop learning.
The tax-protected investments inside many of these accounts (check out the Three-Fund Portfolio) will make us rich slow. Keep in mind that this is how the wealthy get ahead: they use tax minimization strategies and invest. We can’t change the game; we need to get smart and play it.
Under the table are explanations of the terms and what each type of account does.
Investing-geek translations.
Pre-Tax — The contribution is untaxed going in and will come from your company’s business bank account, not your personal account. Remember, you are the employee and the employer. Example: If you earn $100k and contribute $20k to a pre-tax account, your taxable income is now $80k.
After-tax — You have paid tax on the contribution before it goes in. It is not a tax deduction like the pre-tax.
Tax-deferred — It is not taxed as it grows and creates profit. Anything in the account is protected from the taxman during this phase. When you begin to withdraw the funds, it is treated as income and taxed at your income tax rate. That’s the deferred bit, unlike tax-free. This is not bad, though; read on.
Tax-free — It’s all yours, baby! The IRS gets nada when you begin to withdraw it.
Taxable — If taxable in the growth column, gains inside the account are taxed as Capital Gains or as income at your personal tax rate depending on the circumstance as they occur when you sell the asset. Taxable withdrawals will be at your personal income tax rate.
ETFs — Exchange Traded Funds. Think of stock on the exchange but with thousands of companies inside it. Example: SCHB - Schwab Broad U.S. Market has the top 2,500 companies inside it.
Ok, so what are these magical accounts?
Traditional (pre-tax) i401k — This is THE must-have for freelancers; read about it here. You contribute pre-tax dollars to claim a massive tax deduction of up to $76,500 annually. Your investments inside the i401k (see the Three-Fund Portfolio) grow tax-deferred until retirement. You pay income tax when you withdraw money after 59 1/2 in retirement. Most likely at a much lower rate than you did during your working years. Read about how your tax rates work here. If you haven’t kicked this off, get to it as fast as you can.
Roth i401k — Your contributions going in are after-tax, so they are not a tax deduction. The investments grow tax-free, and when you begin to withdraw in retirement, they are tax-free.
I know this sounds attractive, but for most of us, the Traditional i401k above is the way to get the tax deduction during prime earning years.
Mega Backdoor Roth i401k —This is an advanced type of contribution to an i401k; it requires a custom plan from a provider like MySolo401k. The contributions legally get around the limits set on i401k personal and company contributions based on your income. Contributions are after-tax and are roll into a Roth i401k. This is the best way to max out the i401k limit in 2024 of up to $76,500. Post on that coming soon!
Backdoor Roth IRA — The contributions are after-tax and deposited into an IRA. A few days later, you do a ‘Roth conversion’ and roll them into a Roth IRA, where they grow tax-free and are not taxed on withdrawal. The Backdoor Roth gets around the Roth IRA income limits. Yes, this is legal. Make sure your accountant is aware each year you do a conversion.
Health Savings Account (HSA) — This under-appreciated account is a triple goodness tax whammy. Contributions are tax deductions; investments grow tax-free/tax-deferred, and if you spend the funds on qualified medical expenses, they are not taxable. Read about the HSA here. After age 65, you can spend the funds on anything, but that spending is taxable. In this way, the HSA ends up behaving like the Traditional i401k above.
529 Plan — Saving for your kid’s education? Contributions can be partially or fully tax deductible or after-tax (not a deduction), depending on your state. For all states, contributions grow tax-free and are tax-free when you spend them on an education expense. Starting in 2024, you can roll up to $35,000 (lifetime, not per year) into a Roth IRA for the kid. Yes, it’s a bit messy. More info on your state is here.
Don’t underestimate the power of compounding (imagine Darth Vader saying that for some gravitas), $400/month for 18 years, growing at 7% in a Three-Fund Portfolio, will get you around $160,000. Have a play with a compounding calc here; it’s almost magical.
Taxable Brokerage Account—This is a regular brokerage account with someone like Schwab where you buy stocks, ETFs, and Mutual Funds. You can invest in the classic Three-Fund Portfolio, the same as we do in our i401k. Many overlook this account, not realizing it has a big tax advantage.
What’s the tax angle here? If you hold the investment for at least 12 months, you pay the Capital Gains Tax (CGT) rate of only 15%. If your income is over $518,900 in 2024, your CGT rate is 20%. Most dividend payments will also be taxed at the CGT rate.
More than likely, your personal effective tax rate is around 25-30%, so the CGT rate of 15% is a significant tax saving. This is why the wealthy often pay a lower tax rate versus us working stiffs because their income comes from investments, not earned income like wages or a salary. Read about how your tax rates work here.
Savings Bank Account — It’s the least tax-advantaged account and the lowest earner. Contributions are after-tax going in, so there is no tax deduction there. Gains are interest payments made from the bank and are taxed the year you earn them. Not to mention that historically, savings accounts pay you the lowest amount (the return) of any of the accounts. The other accounts use stocks, ETFs, mutual funds, and Bonds, which grow on average by 7-10% per year over the long term.
Cash in a bank is a crap investment. It is liquid, though; you can use it instantly, so handy for emergencies.
Why hasn’t my accountant mentioned even half of this?
The Disney version of your accountant.
Before you call them shouting, ‘WTF!?’, I often hear from freelancers and single-person businesses that their accountant has not mentioned the i401k (aka the Solo 401k) or the Backdoor Roth IRA.
In a way, it’s not their job. They do your taxes, and they’re not financial advisors. Also, the U.S. tax system is an absolute shitshow of complicated accounts and rules. It’s too much for them to keep up with.
Drink more coffee, and keep exploring this site and others to learn all you can. Then tell your accountant to send this site to their clients!
Try this on:
EARN a little more.
SPEND a little less
INVEST the difference
Keep Calm and Invest On
Revisit this list from time to time. If you’re early in your career, you probably won’t have the moolah to add to them all. Start with the Traditional pre-tax i401k and contribute as much as possible. The early money counts the most as it grows the longest, 7% every year, again and again and gain.
Have a regular job and a freelance biz?
If you have a regular job with an employer 401k, max that out first up to when their matching contributions end, then start with the Traditional i401k>HSA>Backdoor Roth IRA.
Higher-income earning freelancers can really max out on these accounts in this order:
Traditional pre-tax i401k>HSA>Backdoor Roth IRA>Mega Backdoor Roth i401k>Taxable Brokerage Account. Throw the 529 in the mix if you have kids.
Suggestions, questions, thoughts? Hit me up below.
Scott Galloway, Professor of Marketing, NYU Stern on investing:
“The good news is, I know how to get you rich. The bad news is the answer is slowly.”