As a high-earning entrepreneur, building a sound investment strategy includes choosing the right type of accounts to invest in that can maximize your money and minimize taxes.
The good news is that there are various investment accounts that can help you accomplish this. However, it's essential to recognize that not all accounts are created equally and have different tax treatments. To navigate this, I want to help you think through an investment account hierarchy based on the tax preference of each account.
In other words…An investment account order of operations for your investment savings to follow.
The first tier is simple but sometimes overlooked. This is an investment in stability. My rule #1, when it comes to financial planning is never to run out of money. Not only does this apply to your business(s), but just as important to your personal financial plan. A strong foundation for entrepreneurs starts with having a good cash position. For most, this is a cash reserve that can cover things that happen in life.
In addition to your cash reserve, you may want to maintain some funds for upcoming opportunities and investments.
This money is generally best in a bank account or cash alternatives within a brokerage account, allowing you to maximize returns while keeping the money accessible.
HSAs are nearly a no-brainer for entrepreneurs with High Deductible Health Plans. These accounts are triple tax-free.
The real power of HSAs comes when you leverage tax-deferred contributions while allowing your HSA funds to grow for the long term. This means you might consider paying for medical expenses out of pocket. Most high-earning entrepreneurs have the cash flow surplus to do this.
By not spending the HSA on medical expenses in the short term, it lets the HSA grow tax-sheltered for many years.
In the future, you can use HSA funds in various ways, including tax-free medical expenses, reimbursements for previous out-of-pocket expenses, or penalty-free withdrawals at age 65. Keep in mind that HSAs have annual contribution limits, which for 2023 are $3,850 for individuals and $7,750 for families.
For entrepreneurs, pre-tax retirement accounts like the Solo 401(k), SEP IRA, and traditional 401(k) plans offer double tax advantages.
Since contributions are made pre tax, in the future distributions are taxable at your ordinary tax rate.
These accounts have higher contribution limits, which can benefit high-earning entrepreneurs, with pre-tax contributions reaching up to $66,000 in 2023. Additionally, 401(k) plans offer an extra catch-up contribution of $7,500 for those over 50.
The total contribution amount allowed will depend on your business type, income, structure, and employee situation.
Retirement accounts are great because they allow you to stash away earnings into a tax-advantaged investment account for the long term. Allowing you to have future optionality outside of your business or self-employment.
Cash balance plans are a way to supercharge retirement savings while deferring taxes. These accounts also offer double tax advantages
These plans are often used in conjunction with 401(k) accounts to maximize tax deferral and savings. They allow for substantial contributions, ranging from around $80,000 to over $300,000, depending on age and income.
Although they are more complex than traditional 401(k) plans, the tax savings and flexibility make them an invaluable tool for high-earning entrepreneurs. Cash balance plans are portable and can be rolled into an IRA at retirement, enhancing your wealth-building and tax-planning options.
A Roth is your tax-free bucket and double tax-advantaged on the back end. You don't get an immediate tax deduction, but the money can grow and is potentially never taxed again.
And you know what's good tax planning? Diversifying your tax buckets and future tax exposure (pre tax and tax free).
Generally, in high-income years, you want to consider deferring taxes like we discussed in tier 2,3, and 4. Still, once you have used up the tax deferral options available to you, the backdoor Roth is a solid next option to diversify away from pre-tax investment accounts. You might even put the Roth bucket as your tier 2 or 3!
The reason for the backdoor strategy is that high-income earners are phased out of direct Roth contributions. This strategy involves contributing to a nondeductible IRA and converting it to a Roth IRA. Be cautious of the pro-rata rule, which may trigger a tax consequence if you have existing pre-tax assets in other IRAs (IRA, SEP, SIMPLE).
Contribution limits for IRAs are $6,500 in 2023, with an additional $1,000 for those aged 50 or older. While not a large amount, this can result in a significant amount of tax-free money in the future.
You can also have a Roth option in your 401k plan. If that's the case, Roth 401(k)’s do not have income limits for contributions. However, you'll want to weigh your options to determine which account type is best for you based on your financial situation and what you are trying to achieve.
A brokerage account is the most versatile investment account. This account can be used for goals and opportunities between now and retirement. Unlike retirement accounts, brokerage accounts have no income limits, contribution limits, or penalties for early withdrawals.
While brokerage accounts are not tax-sheltered, capital gains are typically taxed at preferential long-term rates. In addition, with today's investment options, you can create a very tax-efficient portfolio by selecting tax-efficient investments in a brokerage account. Even though this account is tier 6 based on tax preference, it can easily move up the hierarchy to increase your flexibly outside of retirement accounts.
While it's good planning to have a tax preference focus, it's also important to create an investment hierarchy to reflect your goals first. In other words, don't let the tax tail wag the dog. You may not want to pack as much as you can into retirement accounts if you value mid-term flexibility or don't need to fund as much toward retirement. So be sure to align your investment accounts with your goals first, then optimize for tax.
When you create your own investment account hierarchy, it may not include every account we covered, and that's perfectly fine. Use this hierarchy as a guide to create your personalized order of operations.
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