Having a sound tax strategy is critical to long-term wealth building.
Whether you’re an employee, business owner, or invest in real estate there are tax wise decisions you must make every day. After making a smart tax decision your next step is to decide what to do with your winnings.
To understand a tax strategy, I created a case study for something most of us are familiar with. The choice of a Traditional 401(k) and a Roth 401(k).
Case Study – Vincent and Gretchen
Vincent is a 23-year-old accountant, and Gretchen is a 22-year-old wedding planner. Fresh out of college and into the “real world” they are faced with the decision to choose between the company’s Traditional 401(k) and Roth 401(k).
Together they earn $100,000 of gross income and have a goal to contribute $20,000 total ($10,000 each) to their respective accounts.
Together we decided to model on our handy dandy financial calculator, which option is better for them.
What happens when contributing a flat amount to your 401(k)
Vincent and Gretchen’s decision to contribute a flat amount to their 401(k) resulted in this:
- Total Roth 401(k) Balance at 53 and 52: $547,000
- Total Traditional 401(k) Balance at 53 and 52: $547,000
There are no surprises here. Contributing the same dollar amount every year to either account yields an equal result.
However, there are two major differences not shown in the final balances!
Partnership with the Government
When investing in a tax-deferred account like a 401(k) or Traditional IRA you are creating a partnership with the government. This is best explained in an example:
Vincent and Gretchen are in the 15% tax bracket today and anticipate to be in the same bracket when they retire. When they make their $10,000 contributions, this money is not taxed today, rather it is earmarked to be taxed in the future. Therefore, when they take the money out they are only going to keep 85% of that money. The other 15% is scheduled to go the government upon distribution.
The tax adjusted balances of the two accounts assuming a 15% bracket now and later as well as equal growth rates are as follows:
- Total Roth 401(k) Balance at 53 and 52: $547,000
- Total Traditional 401(k) Balance at 53 and 52: $465,000 (i.e. 85% of the original amount)
As you can see, the results are clear that by using an autopilot strategy like this, the Roth 401(k) creates the larger nest egg. This is even supported by a Harvard Business School study.
After-tax Cash Flow
The second major difference is related to after-tax cash flow.
When choosing to contribute to a tax-deferred account you are saving on income tax today. Here is what Vincent’s and Gretchen’s after tax cash-flow looks like:
- Contributing $10,000 to Roth 401(k): $56,678
- Contributing $10,000 to Traditional 401(k): $61,008
In total, by contributing to their Traditional 401(k) they have an additional $4,330 of additional cash flow.
Hooray for extra cash flow!
Deciding what to do with that extra cash flow plays a major role in your wealth plan. If you don’t have a tax strategy, then you might spend it on lifestyle expenses.
If that’s the case, then you also have more expenses to replace with passive income for retirement. Combine this with your lower overall nest egg and you could create a gloomy future.
However, if you’re looking to build wealth, this is where a tax strategy comes into play.
What if you reinvest those tax savings?
Leverage your tax savings
Reinvesting your tax savings is exactly what a tax strategy is all about.
Create a plan to reduce your tax today. Compound that savings to build your wealth tomorrow.
There are many ways to invest tax savings, but to keep everything simple let’s look at what happens if you reinvest those tax savings into a Roth IRA.
Here are the results after contributing $20,000 total for 30 years into a Traditional 401(k) or Roth 401(k):
- Roth 401(k) accumulated balance at age 53 and 52: $547,000
- Traditional 401(k) accumulated balance at age 53 and 52: $547,000
Of course, the results are the same as above.
Let’s adjust the Traditional 401(k) for its after tax look, assuming 15% tax rate in retirement:
- Adjusted Traditional 401(k) for Taxes: $465,000
Now let’s see what happens if you invest the tax savings of $4,330 into a Roth IRA for 30 years:
- Roth IRA balance of excess cash flow invested: $118,000
Which gets to the grand total of:
Total Roth IRA + Traditional 401(k) Balance: $583,000
This combination provides you with nearly $40,000 more of wealth over the same period! All you did differently was leverage your tax savings.
At the end of the year, you had the same after-tax cash flow available to you cover living expenses, but you invested $4,330 more per year by creating a partnership with the government.
By utilizing your tax savings to your favor, you can create nearly $40,000 of greater wealth over the same period simply by utilizing a tax strategy!
Whatever your goals are there is a tax strategy available to get you there.
This is one example of how one couple can increase their wealth with a tax strategy. Your situation might be different causing the need to for a different strategy. Become educated in this area or work with a qualified expert.
Do you want to understand how to make your money work for you and keep more of what you have earned?
Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Nate Byers a Madison, WI CPA Financial Advisor, and all rights are reserved. Read the full Disclaimer in the footer below.