Let’s talk taxes, shall we?

Here’s what we’ve done so far:

• First, we created our four cornerstones and filled them so we had a single dashboard to quickly spot opportunities.
• We dug for opportunities in cornerstone #1 (ways to save more money) and threats in cornerstone #2 (methods to solve all those horrible “what if” problems).
• We calculated the cost of our goals. In most cases, you’ve been able to now tweak your goals so that you now know what return you need and how much you need to save. For some of you, there’ll be more work to do in this area.

We still have a couple of open loops: in the class I had you map out your goals against each other. More on that later. Also, I’ve had you begin looking at Morningstar, which will come into play as soon as we figure out one little step.

This step is the one most people forget. While it’s important to choose the right investment (what we’ll focus on next), it’s equally as important to know where to place it. In other words, what type of tax shelter should we use?

If you remember our tax triangle, we had three sides:

On the top was tax free investments. These investments are made using after-tax dollars. Money from them isn’t taxed. The bad news? No tax break today. Also, there’ll be some restrictions on getting your money. The good news? Well…no taxes down the road.

What investments are tax-free? Municipal bonds, some cash value life insurance policies (if used correctly) and Roth IRA or Roth 401k (in the USA….many countries have similar tax shelters available). I don’t want to focus on the first two in today’s session because they’re uber-complicated….except to count any money you already have in these places.

Homework: Make a Triangle

Top of the Triangle

Add up all of your tax-free investments so far and place them at the top.

Bottom Right of the Triangle

On the lower right side of the triangle is tax deferred money. In most cases, you can write these off today’s tax forms OR you’re able to invest pre-tax through a work plan. This would include a Traditional IRA, a 401k or 403b plan, or annuity.

Add up the money you have in these investments and write the sum in the lower right corner.

The good news about these investments? They give you nice tax breaks today (most of the time) and also allow you to invest tax deferred. The bad news? There are no tax savings when you withdraw funds and there are limits on how/when you can remove money.

Bottom Left of the Triangle

Finally, in the lower left corner are taxable accounts. These accounts give you NO tax breaks, but you can get at them whenever you choose. You may pay taxes as you go on dividends or capital gains AND you might pay taxes when you sell. These investments give you ZERO tax breaks, but lots of flexibility.

What goes here? Every “investment” (excluding your emergency fund) that’s outside of tax shelters.

You already know what to do here:

Find the sum of all your flexible investments and write the total in the lower left corner.

Now, look at your tax triangle and see how the legs compare. Is one really big? Is one nonexistent?

The reason you want all three sides of the triangle is this: you want tax breaks today….but you also want tax breaks later in life….AND you want flexible money.

The point:

This exercise will tell you whether you should choose a tax free account like a Roth IRA over a 401k plan or Traditional IRA. It’ll also show you visually if you don’t have enough flexible money. Tax savings are great, but you want to balance your three sides of the triangle.

Most people have more money in Traditional IRAs and 401k plans than anywhere else. If you do, that’s fine. However, if you have MOST or ALL of your money in that corner, you’re in trouble later. Conversely, if you have a large amount in Roth IRAs, you might be missing out on some easy tax breaks right now.

See how cool it is to visually make decisions? We’ve been able to do that with the 4 cornerstones and now with your tax situation!

Next lesson, before we choose investments, we’ll do the same with your goals by finishing up your goals timeline.