Money Minute Episode 2: Types of Money & Tax Diversification

Taxes. For some, that word causes panic. For some, that word causes anger. That word almost certainly brings joy to no one (except Uncle Sam, obviously).

A few questions for you:

  1. Do you enjoy paying taxes?
  2. What is your effective tax rate?

I’ve yet to meet someone who answers question 1 with a yes. Some may not mind paying taxes, but nobody enjoys it. The second question gets a wider range of answers. Many think they know their effective tax rate but really what they know is their tax bracket. To figure out your effective tax rate, look at your Form 1040 and divide the number on line 24 by what appears on line 15. The result is the tax rate that you are actually paying.

This goes to show that many people don’t know what they’re paying in taxes, but they know they don’t like paying taxes. Why then do most people spend very little time diversifying their assets from a tax perspective? Why do most people fail to position themselves to avoid a tax-bomb in retirement?   It is either a lack of education or a lack of effort. With this post, I’ll provide the education. You provide the effort.

To truly understand tax diversification, we must understand what types of money exist and how each of these will be treated during accumulation (saving for retirement) and, most importantly, during distribution (retirement).

There are four types of money (ranked in order from best to worst):

  1. Free money
  2. Tax-advantaged money
  3. Tax-deferred money
  4. Taxable money

This week we will focus on the first two types of money: free money and tax-advantaged money... the best types of money.

FREE MONEY

Free money is the best kind of money regardless of tax treatment because, in the end, you have more money than you would have otherwise. Typically, we see free money in the form of employer matching in a workplace retirement plan. Let’s say that an employee earns $50,000 annually and contributes 3% ($1,500) to their retirement account annually. The employer matches that employee’s contribution and puts in 3% ($1,500) to the employee’s account. That is $1,500 in free money. Take all that you can! Keep in mind that any employer contribution will still be subject to taxation when withdrawn.

TAX-ADVANTAGED MONEY

Tax-advantaged money is the next best thing to free money. Although you must earn tax-advantaged money, you do not have to give part of it to Uncle Sam. Tax-advantaged money comes in three basic “forms” that you can utilize during your lifetime (four if you want to include prison in your retirement plan).

One of the most commonly known forms of tax-advantaged money is municipal bonds, which earn and pay interest that could be tax-advantaged on the federal level, the state level, or both. There are several caveats that should be discussed regarding tax-advantaged income from municipal bonds. In the interest of time, discuss this with your financial advisor.

The Roth IRA is probably the single greatest tax asset that has come from Congress. They are well known but rarely used (compared to traditional IRAs). The main difference between a Roth and traditional IRA lies in the timing of taxation. We are all very familiar with putting money away for retirement through an employer plan. This money is taken out before taxes are calculated, meaning we do not pay tax on those earnings today. We contribute to a Roth IRA after the money has been taxed (no tax benefit today). The other significant difference between these two is taxation during retirement (or whenever the money is distributed). With traditional IRAs, distributions are added to our ordinary income and are taxed at our ordinary income rate. Distributions from Roth IRAs are tax-advantaged – free from tax (if we meet all the requirements).

What's the difference between an IRA and a 401(k)? We covered that on this week's episode of Money Minute, which you can find at the bottom of this post.

So why doesn’t Warren Buffett and Elon Musk have a Roth IRA if they are so good? There are several reasons, but the biggest reason has been the earning constraints on contributions. If you make too much money, you cannot contribute to a Roth IRA (through the traditional method – discuss this with an advisor).

Life insurance is the little-known or little-discussed tax asset that holds some of the greatest value during life and upon death. Most view life insurance as a way to protect our loved ones from financial ruin upon our death. All morbidity aside, the best part of life insurance is that the death proceeds are tax-free – what a huge benefit that is! The downside – we don’t get to use it. Our heirs reap the tax benefit.

Life insurance can be used for so much more than death proceeds and if positioned properly, can result in tax-advantaged money while you’re living. Again, this would need to be discussed with an advisor.

Stay tuned for next week - Ryan will be breaking down the last two types of money!

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