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How to Set Up a Tax-Efficient Investment Waterfall

Author Alvin Yam

As a busy physician, you don’t have a lot of time to spend on carefully optimizing the tax efficiency of your personal investments. This involves considering many areas of your financial life, such as your time horizon, investment goals, and your tax situation.

Figuring out how to best allocate your money among the many savings and investment vehicle types can be confusing. It also involves choosing from amongst different account types, such as retirement plans and accounts, taxable accounts, and health savings accounts. Each type of account has its features: tax benefits, investment options, contribution limits, withdrawal rules, and fees. 

However, adopting a strategic approach to your investments can greatly maximize your net returns and grow your wealth over the long run. 

So, how do you make sense of it all, and what’s the best approach to prioritizing your investment and savings account strategy?

First and foremost, you should start the process by establishing a solid financial plan. Yes, this is obvious, but it’s worth stating. 

Doing this will help you understand your essential and discretionary spending so you’ll be able to make informed decisions about your savings and investments. This means starting by making a detailed budget that tracks where all your money comes from and goes each month. You’ll need to assess all your current expenses and discretionary spending. Also, factor in periodic costs like insurance premiums, taxes, and other variable expenses.

Many budgeting apps are available to help track your spending, such as YNAB (You Need A Budget). We have also reviewed Projection Lab, a more advanced app that offers enhanced monetary planning and projections features.

The goal is to figure out what you really need to spend to live day-to-day versus all the “extra stuff” you might be able to cut back on. 

After you have your budget in place, the next step is prioritizing where to allocate your funds based on each of your account’s unique tax profiles and benefits. This is where the concept of a “tax-efficient waterfall” comes in.

 

What is Tax-Efficient Waterfall

The Tax-Efficient Waterfall involves allocating your extra dollars sequentially to the most tax-advantaged accounts available, such as your 401(k)s, IRAs, and health savings accounts, before your taxable brokerage and savings accounts. 

Instead of first focusing on individual investments, this method prioritizes where to put your money based on each type of account’s tax treatment. 

Maximizing the use of your tax-advantaged accounts upfront allows returns to compound faster since more of the investment principal and earnings are shielded from taxes. Contributing to taxable accounts first results in paying unnecessary taxes that eat away at your returns. Here is the order of the waterfall:

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How to Set Up a Tax-Efficient Waterfall

Step 1. Contribute enough to employer-sponsored retirement plans for employer matches

First, fund your employer-sponsored retirement plans, which allow you to either defer taxes on your contributions and earnings until retirement (e.g., traditional plans such as 401k and 403b) or pay taxes upfront and enjoy tax-free withdrawals in retirement (e.g., Roth IRA and designated Roth 401k or Roth 403b accounts).

Many employers will make matching contributions to your 401(k) or 403(b) plan up to a certain percentage of your salary. You should contribute at least enough to take full advantage of the match. For example, if your employer matches 50% of your contributions up to 6% of your salary, you should contribute at least 6% of your salary to your plan. This is essentially free money that gives you an immediate return on your contribution.

Step 2. Pay off high-interest debt

Next, pay down high-interest debt. Carrying balances on high-interest debt almost always costs far more than your investment returns will earn. This is why the next step in the waterfall method is eliminating any debt with an interest rate higher than your expected investment return. This typically includes credit card debt, personal, car, and student loans. 

You should focus on paying off the debt with the highest interest rate first while making minimum payments on the rest. This is also known as the “debt avalanche” method.

The alternative is to use the “debt snowball” method, which involves paying off the smallest debt first and then moving on to the next one, popularized by Dave Ramsey.

 

Step 3. Max out contributions to other tax-advantaged accounts

The next step is to contribute to your other tax-advantaged accounts, such as HSAs, additional 401(k) contributions, and IRA accounts. 

A Health Savings Account (HSA) is a unique account that offers triple tax benefits – you can deduct your contributions, your earnings are tax-free, and you can withdraw money for qualified medical expenses without paying taxes. Some key features of HSAs are:

– HSA contributions can be made pre-tax through payroll deductions to lower your taxable income.

– Money in your HSA grows tax-deferred and can be invested in ETFs and funds, similar to an IRA. Withdrawals are also tax-free if used for qualified medical expenses. 

– HSA funds roll over from year to year if not spent, and you own the account even if you change jobs or health plans.

– HSA contributions, earnings, and withdrawals for medical care are all exempt from taxes. 

– Money saved in an HSA can grow over time much more than money kept in savings accounts.

After maxing out your HSA, max out your 401(k), 403(b) or other company-sponsored plans. The earnings grow tax-deferred in these traditional 401(k) or 403(b) accounts. 

If your employer offers the designated Roth account options, contributions to your Roth 401(k) and Roth 403(b) accounts grow tax-free. With a Roth 401(k) or Roth 403(b), your contributions are made on an after-tax basis, which means your contributions to Roth accounts have already been taxed as regular income in the year you make your contribution.

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From here, you’ll make contributions to an IRA. A traditional IRA gives you an upfront tax deduction, while a Roth IRA doesn’t provide a deduction but provides tax-free withdrawals in retirement. Roth IRAs will typically provide greater tax savings over time compared to a traditional IRA because Roth IRA-qualified distributions in retirement are completely tax-free.

 

Spousal IRA contributions

For married couples, you can also take advantage of spousal IRA contributions. If one spouse does not have earned income, the working spouse can make contributions to an IRA on behalf of the non-working spouse as long as the couple files a joint tax return.

In 2024, the contribution limits for both traditional and Roth IRAs for individuals under age 50 will be $7,000. If you’re 50 or older, the limit is $8,000.

So, if both you and your spouse are 50 years of age or older, you could potentially contribute a total of $16,000 ($8,000 for each of you) to your IRAs in 2024. This is in addition to any contributions you make to your employer-sponsored retirement plans.

 

Step 4. Explore cash balance plans, non-qualified deferred compensation, solo 401(k)s, and mega backdoor Roth conversions

Now that the tax-advantaged retirement accounts are funded, you can explore other tax-advantaged account options.

For higher-income earners, typical 401(k) and 403(b) plans hit annual contribution limits, making it difficult to invest much in retirement savings. Some employers offer cash balance plans and non-qualified deferred compensation plans, providing additional tax-efficient saving opportunities. Cash balance plans function like traditional defined benefit pension plans but define benefits using a hypothetical account balance. They allow larger contributions proportional to salary than a 401(k). Earnings accumulate tax-deferred, and benefits are taxed as regular income upon withdrawal.

Non-qualified deferred compensation plans (NQDC) enable certain highly compensated employees and executives to contribute amounts above normal qualified plan caps. Contributions are not subject to payroll taxes, and earnings are not taxed until funds are distributed, usually after separation from service. 

If you’re self-employed, you can open a solo 401(k) with much higher contribution limits than a traditional IRA. The upshot is that it enables you to put away much more for retirement each year on a pre-tax basis. For 2024, the Solo 401k contribution limits have increased to $69,000, with an additional $7,500 catch-up contribution if you are 50 or older, bringing the total to $76,500.

Lastly, consider mega backdoor Roth conversions. This retirement savings strategy simply allows high-income earners to take the after-tax dollars they contribute to their 401(k) or 403(b) plan and roll them into a Roth IRA. With this strategy, you are essentially contributing more money to a Roth IRA than the annual contribution limit. You can read our article on The Mega Backdoor Roth IRA: A Comprehensive Guide (2023).

Step 5. Invest the remaining funds in regular brokerage or savings accounts

The last step in the waterfall method is to invest any excess money that you have after funding all the previous accounts.

This money can be invested in taxable brokerage accounts or savings accounts. You’ll be able to choose from a huge range of investment options with these accounts, such as stocks, bonds, ETFs, REITs, or alternative investments. These accounts don’t offer any tax benefits, but they give you flexibility and control over your investments.

The main benefits are flexibility and accessibility, as you’re able to access this money at any time without any penalties or restrictions, and it can be used easily for emergencies.

 

Tax-Efficient Investment Waterfall in Action

Here is a hypothetical scenario showing how Kathy, a 50-year-old physician earning a $200,000 annual salary, has an extra $150,000 to allocate to retirement and investment savings. She’s married and files taxes jointly. 

  1. Kathy contributes $12,000 (6% of her $200,000 salary) to her 401k plan to take advantage of her 50% employer match, which amounts to $6,000.
  2. Since Kathy doesn’t have any high-interest debt, she can skip this step.
  3. Kathy maxes out her HSA with family coverage at $8,300.
  4. Kathy contributes the remaining $18,500 contribution amount to her 401(k), which brings her total annual 401(k) contribution to $30,500 ($23,000 plus $7,500 catch-up contribution).
  5. Kathy contributes $8,000 to her Roth IRA and also $8,000 to her spouse’s Roth IRA as a Spousal IRA contribution ($7,000 plus $1,000 catch-up contribution each), for a total of $16,000.
  6. Kathy makes $32,500 in after-tax contributions in her 401(k) plan as part of a Mega Backdoor Roth conversion strategy.
  7. The remaining $62,700 is invested across her taxable brokerage accounts.

 

Final Thoughts

By using the tax-efficient waterfall method, you‘re able to ensure that you use all the tax benefits available before your funds are taxed at a higher rate later on. 

This waterfall method can simplify and optimize your tax and investment strategy and boost your returns over time. By prioritizing and allocating funds in a systematic way, you can minimize the amount of money that goes to Uncle Sam and instead put it to work for you. Over the long run, this can add up to tens of thousands of additional dollars.

Are there other approaches to creating a tax-efficient long-term investment plan? Yes, but I’ve found that this waterfall method is a great starting point and works so effectively because of its simplicity and easy to follow.

 



 

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2 thoughts on “How to Set Up a Tax-Efficient Investment Waterfall”

  1. Hi rm,

    Glad you enjoyed it and it’s great to hear that you’ve already been implementing this strategy.

    Best,
    Alvin

    Reply
  2. Subscribe to get more great content like this, an awesome spreadsheet, and more!
  3. This is a very well-organized strategy. I have been doing this; however it is nice to see it written about so clearly. Thanks for the knowledge.

    Reply

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