There are tax advantages that can make early retirement possible. Many people don’t know about these tax strategies and they might be able to retire years earlier than they expected!
No wonder Americans are so poor! They pay 29.6% of their income to the federal government, which is more than they save for themselves. This means many people have no money left over after taxes and must live paycheck-to-paycheck with little or nothing saved up for emergencies or retirement.
Americans looking to build wealth quickly should take advantage of their tax bill by increasing their savings rate. This is because it takes a high savings rate in order for one’s passive and investment income alone to cover living expenses so they can reach financial independence early (FIRE).
Want to be financially free before the age of 40? Try these tips designed to save you money, minimize your tax liability and ensure that when it’s time for you to retire from work at any given point in life, there will always be funds available.
Using Tax Advantage Strategies So You Can Retire Early
Begin With an Independence Plan
Before you can optimize your tax strategy for financial independence, you should have a clear vision of what it means to be financially independent and how this will affect the sources from which income is derived. This includes having age as a target that determines when one has reached true “financial independence”, as well as setting an amount that represents current passive income (or potential future passive incomes).
The age at which you can withdraw money from tax-sheltered account matters because, if you’re under 59 and ½ years old, then the only way to get your hands on that cash is by selling off assets in any paper accounts. And it doesn’t help that these types of accounts are made for investing in things like stocks or bonds but not other forms of investments.
A financial independence plan can be built from the following four building blocks:
- money in savings and investments
- income or salary to invest
- investment accounts.
Many people pursuing financial independence retire early (FIRE) invest in real estate, which is another staple investment.
While some investors choose to buy properties directly, they can also invest in real estate by other means. For example, through notes (private or crowdfunded), loans like Groundfloor’s real estate investment trusts (REITs) such as Fundrise and Streitwise.
Investing in real estate can balance your FIRE portfolio, but it’s harder to get a good return on. It is more stable than stocks because of its lack of liquidity and long-term benefits from inflation.
Also, real estate is a valuable investment because it provides an additional way to diversify your portfolio and protect against significant loss in the stock market.
Rental properties and funds that own or lend against them generate income immediately and forever. Like stocks, real estate also tends to appreciate over time but unlike stocks more of its returns come from income rather than appreciation.
Unfortunately, tax-sheltered accounts are necessary for investing in publicly traded real estate investment trusts. The good news is that there are other ways to reduce your taxable income by investing in real estate!
Stocks have several benefits for your portfolio.
Stocks are one of the most notable investment types available to you, and they can help simplify investing when done correctly.
Stocks give investors access to a market that has historically performed better than other investments over time with less risk involved because it’s diversified across many companies instead of just being concentrated in one company or industry which could be volatile if something bad happens at said company/industry making their stock prices drop drastically compared to another similar but unaffected company thus giving an unfair advantage towards picking only stocks from stable industries while ignoring risky ones even though there is still potential value within them.
First, they generally offer strong long-term growth. During the past century, 10% has been an average of around annual returns from price appreciation rather than dividends in S&P 500 which is a stock index based on market capitalization and can be used as benchmarks for various types of investments such as mutual funds or hedge fund strategies.
A second reason why mutual funds and ETFs are great investments is that they offer diversification.
With a single purchase of one, you can buy shares in hundreds or even thousands of companies without having to go through the process of buying each individual stock on your own. This makes it easy for investors with limited time (or capital) to gain exposure to stocks from around the world with just several different funds – regardless if those come from large-cap corporations or small businesses both domestically and abroad.
Some of the benefits associated with stocks include being able to buy or sell them at any time, and they provide a good way for you to have access to your money.
Stock trading is a great way to invest your money and make more of it. You can buy or sell stocks easily in any tax-sheltered account you want, such as an IRA or 401(k).
Stocks are a staple in the portfolio of nearly everyone pursuing FIRE because they offer numerous advantages. These include: there’s no barrier to entry, stocks frequently pay dividends and capital gains, you can easily diversify your holdings by purchasing an index fund or ETF (exchange-traded funds), and it’s easy for beginners as well due to their lower risk than other investments like real estate or precious metals.
Investors consider bonds to be lower-risk, lower-return investments often used in preparation for retirement. Many investors use them as protection against Sequence Risk – the risk of a market crash early on during an investment horizon.
If you build a portfolio that can support you indefinitely through ongoing real estate income, stock dividends, and a low withdrawal rate, there is no need to worry about sequence of returns risk because your money doesn’t go down over time.
When you retire young, there are other ways to supplement your investment income if needed. You can always start a side hustle like working part-time or starting a hobby business. Nothing stops younger adults from earning more money in case their investments aren’t enough!
With a low-interest rate, people pursuing FIRE can skip the lower returns of bonds if they want to. This will allow them to keep their money in higher-yield investments instead.
Sample Plan for Independence
My hope is to become financially independent in the next five years. I have a plan that could work, but it’s flexible because things can change quickly when you’re working toward your goal:
I’d like to reach financial independence within five years and my strategy might be achievable if certain conditions are met. My plan would look something like this…
Stock Income: I save about 20%-30% of my budget to accumulate enough dividends and funds for a 3.5% withdrawal rate if absolutely necessary.
Direct Real Estate Income: The percentage of my budget, made up of cash flow on rental properties is 30% to 40%.
Indirect Real Estate Income: I invest 10% to 20% of my budget in private REITs and other notes. I do this because it is an easier way for me to get into real estate investments with people that I know personally, who are investors themselves.
Passion Project Income: I’ll always do something fun and productive with my time, even though it may not pay well. I spend about 20%-30% of my budget on this habit because that’s just the type of person I am!
Strategies for Tax Sheltered Accounts
There are several ways that tax-sheltered accounts can help you on your journey to financial independence and retirement.
Tax-sheltered accounts, such as a 401(k) or other employer plans, often offer an automatic matching component from the company’s investment account. This means that if you contribute $5 per paycheck yourself ($500/year), then the money in those companies’ coffers will automatically double for investing purposes each year ($1,000).
The power of compound interest is strong with this one! In addition to any match by employers who have some sort of plan going (many do not these days, unfortunately!), even small amounts over time add up quickly when compounded at 8% annually while saving costs associated with withholding taxes until withdrawal
A few of the most useful accounts are those that allow you to build lasting wealth. These include traditional savings, investment vehicles like stocks and bonds, tax-advantaged retirement plans such as 401(k)s or Roth IRAs, real estate investments made through your company’s Employee Stock Ownership Plan (ESOP), inheritances from family members including parents but not children who do not have their own means of supporting themselves financially at age 18+ years old, charitable trusts left in a will for established charities with verifiable mission statements.
The following account types prove particularly useful when building lasting wealth: Traditional savings Investment vehicles, Tax-advantaged retirement plans, Real Estate Investments Inheritances, and Charitable Trusts.
With a Roth IRA, you can leave your contributions invested and untouched to draw on them when you’re 59 ½ or older. But because of the flexibility this savings tool offers, it’s possible for individuals to utilize their funds in many different ways other than retirement purposes such as paying off expensive debts like student loans.
Roth accounts double as emergency savings vehicles you can tap into any time. You can withdraw your contributions at any time without penalty so they are a good option for those who might need to access their money right away.
Your Roth IRA can also be used for other major life goals, such as paying for college tuition. The government even allows a special exemption to withdraw up to $10,000 from your Roth IRA’s earnings tax and penalty-free when you buy your first home.
So, why choose a Roth IRA? Well, there are plenty of reasons: tax-free retirement income and the flexibility to withdraw your money whenever you like.
Employer-Sponsored Retirement Accounts
When you’re ready to start saving for retirement, there are a few different types of accounts that can help. If your employer offers one of the following plans: 401(k), 403(b), Thrift Savings Plan (TSP) or SIMPLE IRA – take advantage! These all offer higher contribution limits than traditional and Roth IRAs.
There are a few different types of employer-sponsored retirement accounts. Corresponding to traditional IRAs, most have tax deductions now and offer the option for contributions that can be withdrawn later without being taxed or penalized. In addition, they all allow you to invest your money with more flexibility than just these two options as is provided in an IRA through Roth investments.
(The exception: SIMPLE IRAs don’t allow a Roth option)
The real value of an employer-sponsored retirement plan lies in the matching contributions. It’s effectively free money – just for doing what you should be doing anyway: investing and building wealth. Employees who are fortunate enough to receive these matchings, however small or big they may seem, must make sure that every year is maximized so as not to miss out on this valuable opportunity.
In 2020, the self-employed can open up a solo 401(k) account and contribute to it. Contributions are capped at $57,000 that year. You won’t receive any free money from employer matching when you put your own funds into your personal retirement savings plan though!
Traditional IRA or SEP IRA
Like a traditional IRA, SEP IRAs allow you to reduce your taxable income today while simultaneously preparing for retirement tomorrow. Additionally, this year’s contribution can be deducted which should save some tax money in the process! Finally, unlike Roth accounts where withdrawals are taxed as ordinary income (with after-tax dollars) and Traditional Accounts with pre-tax contributions that grow untaxed until withdrawal; distributions from both types of SEP account will not be considered “ordinary income.”
Starting your own business comes with a lot of perks, and the SEP IRA is one of them. You can contribute up to 25% of self-employment income which has a cap limit of $57,000 in 2020. This only proves how beneficial it could be for you as an entrepreneur!
Deductions can save you money by reducing your taxable income, preventing you from spilling into a higher tax bracket. This allows more of the money that would have been lost to taxes for investing elsewhere.
This cushion will protect you in the future when retirement accounts are more important than ever.
With my focus on investing in the stock market, I use tax-sheltered retirement accounts to automate monthly investments. These are easy to set up with a Robo-advisor – they even rebalance for you so your money is invested smartly without much effort from you.
Roth IRAs are better than traditional and SEP IRAs for pursuing FIRE because you can withdraw the money when you need it before age 59 ½ without penalty.
But they can be extremely helpful to have in your golden years as a backup plan if you are struggling financially or cannot afford health care costs.
Self-Directed Retirement Plans
All of the retirement accounts listed above share one limitation in common. They only let you invest in publicly traded assets like stocks, bonds, and public REITs. What if you want to invest in property or other alternative investments?
If you want to set up your own retirement account, there are several options: self-directed IRA (Roth and SEP), solo 401(k).
There are some caveats when it comes to these plans.
In a traditional 401k, you have certain investment options that may or not be what’s best for your personal situation. In an IRA account, on the other hand, you get total control over any investments in there and can switch things around as often as needed without having to close out one plan before opening another!
If you choose a self-directed IRA, the custodian has to approve your investments before they can be funded. This could delay investment and cost time for price-sensitive opportunities. Usually, the custodian charges an additional fee each time one of these investments is made decreasing returns significantly.
Alternatively, you could opt for a checkbook IRA. In this option, all contributions are first deposited into an LLC that you own and control. Then your funds can be used towards any investments of your choosing with no custodial approval or per-transaction fees to pay along the way. However, it is important to note that there will likely still be some annual fee as well as fines if prohibited transactions occur under Self Directed Accounts (SDAs).
The input provides information on different options available when establishing a self-directed account through which one would use their retirement savings to invest in real estate among other things without needing permission from those who manage these accounts such as banks/trust companies etc… The output reflects how by using a checkbook IRA instead
Self-employed people with no employees have more freedom when it comes to their 401(k) plan. They can fully control their own account by using a self-directed solo 401(k). This option allows them the ability to make investments, without needing approval from any custodian first for every single investment made.
If you’re an experienced real estate investor, then investing in real estate is a good option for you. However, if it’s your first time as an investor or on the fence about whether to invest or not, we recommend staying away from these options and sticking with traditional stocks and bonds instead.
Although there are more investment opportunities than ever before such as modern-day types of investments like cryptocurrency and peer-to-peer lending which don’t involve banks at all; but they come with great risks that can leave new investors broke faster than ever especially because this also means greater freedom to lose everything due to poor decisions without anyone holding them accountable except themselves under these scenarios where no one else has any control over their money anymore since it’s solely up to them.
Health Savings Account
With a health savings account from Lively, you can get the best tax benefits of any other type of insurance plan.
Make sure to take advantage of this amazing deduction in 2020! It allows you up to $3,550 for individuals and $7,100 for families. When the money is put towards qualifying health care expenses it grows tax-free as well so your hard-earned cash will work just a little bit harder when invested into an HSA account.
The costs of healthcare can be quite extensive. Healthcare expenses include not only doctor appointments and hospital bills, but also prescriptions, over-the-counter drugs, eyeglasses/contact lenses, dentist visits, acupuncture treatments. It even includes fertility treatments!
Unlike retirement accounts that have an age floor of 59 1/2, you can withdraw money from your HSA at any time to cover these expenses. But instead of having to withdraw the money when you pay for the expense–you can actually take out this money in all tax years!
The benefit of an HSA is that you can use it as a tax-advantaged emergency fund. If, for example, you get hit with $1,000 health bill and pay for it out-of-pocket using your checking account leaving the money in your savings untouched to compound interest-free from taxes then this would be beneficial because all those funds will remain safe during emergencies without being taxed later on when withdrawn into retirement accounts or used towards medical expenses at any point in time after reaching age 65.
If you encounter a medical emergency during the year and your available monthly operating budget doesn’t cover it, then you can withdraw money from your HSA to retroactively pay for any expenses.
You can also use your HSA as a tax-free way to pay for tampons, Tylenol, and other medical necessities.
To top it off, HSAs are a great secondary retirement account. For one thing, you’ll find plenty of qualifying health expenses in retirement.
You can use your HSA as a tax-sheltered emergency fund and health-related spending account.
Limitations of Tax-Sheltered Accounts
Many young adults think that their tax-sheltered accounts are enough to sustain them for the rest of their lives. However, you cannot live on these types of investments alone because they do not produce income. You need a taxable brokerage account and other taxable investment vehicles in addition to your 401(k) or IRA so that you can generate an extra source of income while growing your retirement funds at the same time.
As noted throughout, you cannot withdraw money from your traditional IRA or SEP-IRA before age 59 1/2 without incurring taxes and penalties. You can claim an exemption if the funds are used for buying a first home.
Because the age restriction raises an important question, how do you generate passive income in the meantime?
In order to achieve financial independence, you need to build an ongoing income that can cover living expenses starting now. Tax-sheltered accounts help with building wealth but cannot be used as a way of achieving the goal today because they are taxable and not accessible for emergencies.
This is why it’s important to save outside of traditional retirement accounts, like a Roth IRA. These savings should provide enough funds for you to live until the money in your tax-advantaged account becomes accessible without penalty.
Challenges for Alternative Investments
Unless you use a self-directed retirement account, it is possible that your investments may not include real estate or other alternative assets. Alternative investments are often riskier than traditional investing but the returns can be larger and they typically provide higher yields on income.
Interest rates are low, and the stock market is volatile. You can’t make money without paying taxes on it. But real estate offers tax benefits that other investments don’t have! The interest you spend, property upgrades – even maintenance costs for things like lawn care all count as deductions when filing your income taxes with investment properties in mind.
With low interest rates available on taxable funds, you might want to invest in income-generating investments like real estate for immediate returns. You can also consider alternate long-term investment opportunities through tax-sheltered accounts that offer attractive interest rates and growth potentials over the years ahead of us.
Investors should consider investing in stocks through their tax-sheltered accounts for long-term growth and using taxable funds to deal with alternative investments like real estate for immediate income today.
Some of the benefits associated with financial independence are surprising. For example, retiring early may not be possible for some people because they do not have enough money saved up to retire comfortably.
However, there are other unexpected rewards that come along with being financially independent, such as having more time and flexibility in your schedule or becoming a better parent by spending more quality time at home instead of working long hours on weekends or after-work nights.
As you get closer to FIRE, the risk of job loss fades in relevance and urgency. If a recession hits your industry or company, you won’t starve because by then you will rely less on employment income for survival.
FIRE is a term used to describe financial independence, retirement early. If you are able to achieve this status for your family, then it means that without the need of working full-time in order to survive financially each month.
You can instead focus on growing investments and other money-making opportunities that will allow for an even more comfortable lifestyle than what might have been enjoyed had one continued with their career at another company.
Having less reliance on income from employment allows families who practice FIRE principles to also reduce costs through items like life insurance or long-term disability insurance – savings could be funneled into increasingly greater investment assets as well!
If you don’t need your job to survive, negotiate a higher salary and benefits from the position of strength. You can then invest this money into building wealth for yourself or put it towards daycare costs so that one spouse could go part-time at work while caring for their children.
The more passive income you have, the easier life gets. The less need for your job to cover bills means increased freedom and flexibility.
Tax-sheltered accounts help you save more money, pay less in taxes and keep tax-free emergency funds. However, to reach financial independence at an early age the bulk of your investments need to go through taxable accounts and assets.