Read time: 7 to 8 minutes
Saving more helps, but there are other factors, too. In this article, discover how you can get ahead with a few easy steps.
You only keep the dollars you save
It doesn't matter how much you make. When it comes to creating wealth, what counts is how much you keep.
Financial author David Bach writes that he can predict a person's future from one simple factor—how much they save.*
| If you want to be: | Do this with your money: |
|---|---|
| Dead broke | Spend more than you earn |
| Poor | Spend everything you make |
| Middle class | Save 5% to 10% |
| Upper middle class | Save 10% to 15% |
| Rich | Save 15% to 20% |
Start with your plan
To build wealth, the natural starting place is your employer’s retirement plan. It offers important tax advantages, and often your employer offers a matching contribution.
Given its advantages, it’s surprising that only about 14% of workers save themaximum allowedby law in their plan. Even among those making more than $100,000, only about one-third contribute all they are allowed.**
If you want to achieve the freedom to retire at the age you choose, travel the world, or send your children to college, save like a champion. Start by contributing all you can to your plan.
*David Bach,The Automatic Millionaire,New York: Broadway Books, 2004.
**How America Saves 2022, Vanguard, 2022.
Open the back door to a Roth IRA
Because the money in a Roth IRA can grow and be withdrawn tax-free, it can be an indispensable savings tool.
After maxing out their retirement plan, many wealth builders contribute every dollar allowed to a Roth IRA. But as you may know from experience, income limits can prevent high earners from contributing to a Roth IRA.
There’s another way in!
If you can’t contribute directly to a Roth IRA, consider going through the back door. Here’s how it’s done:
- Make a nondeductible traditional IRA contribution.
Open a traditional IRA account and make a nondeductible contribution. (Come tax time, you’ll need to report your nondeductible traditional IRA contribution by completing IRS Form 8606, Nondeductible IRAs.)
- Convert the nondeductible traditional IRA to a Roth IRA right away.
Quickly roll over that traditional IRA to a Roth IRA. Speed counts, because any earnings that you convert to the Roth IRA would be reported as taxable income in the year of the conversion. (You will owe taxes on the contributions you convert because they were made with after-tax money.)
Learn more about Roth
Learn how Roth contributions can get you tax-free retirement incomehere.
Special tax considerations
Consult a tax advisor if you have any other traditional IRAs. In this instance, you are required to treat the conversion as if it came proportionately from all of your IRA assets. The result? Some of your converted amount will be subject to taxes.
Share your employer’s success
As a reward for your hard work, some employers allow you to invest in your company's stock.
It can be through a stock purchase plan, through stock options, or through your retirement plan.
Investing in your company’s stock can allow you to share in your company's success. Just remember that a single stock is much more volatile than an investment in a diversified mutual fund. (Remember Enron?) That’s why Vanguard suggests that you invest no more than 10% of your overall retirement savings in company stock.
Tax-saving tip: Consider taking advantage of potentially lower capital gains taxes versus ordinary income taxes. When you roll over your stock to an IRA or sell it and withdraw the money, the entire amount will be taxed as ordinary income when the stock is sold.
Instead, consider transferring the stock from your plan "in kind" (that means without selling it) to a taxable brokerage account. You would owe ordinary income tax on the cost of the shares, but any unrealized gains on the shares could be taxed at a lower long-term capital gains rate.
Consult a tax advisor before rolling over shares of company stock.
Whenever you invest, there's a chance you could lose the money.Diversifying means having different types of investments. It doesn't guarantee you'll make a profit or that you won't lose money.
Whether you keep your money where it is, move it to an IRA, or move it to another employer's plan depends on your situation and preferences. Some things to consider are available investments and services, fees and expenses, and protection from creditors. Also consider withdrawal penalties, required distributions, and the tax effects of moving company stock to an IRA. There are other factors too. Weigh the pros and cons before you make your decision.
Start saving for college early—really early
You probably already know that college costs a lot of money.* That’s why it pays you to save like a hero while your kids are still little.
There’s a genius way to save for college that may provide both state and federal tax advantages. It’s called a 529 account, and it’s available in every state.
The 529’s tax advantages
Many states give you a deduction or a credit for 529 contributions, potentially reducing your state income tax bill.See whether 529 contributions might reduce your state taxes.
Money contributed to a 529 will grow tax-free, similar to the dollars in your retirement plan. If you spend 529 money on qualifying college expenses (such as tuition, fees, and room and board), you won’t owe federal or state taxes on the withdrawals.**
Tax breaks can make every dollar you save for college go farther.
When to look beyond your state’s 529 plan
In some states, you will need to contribute to your state’s 529 plan to qualify for a state income tax deduction. But high fees or sales charges associated with your state’s plan might outweigh its benefit. In that case, consider finding a top-rated, low-cost 529 plan in another state and skipping your state tax deduction.
*The average cost of tuition and fees, not including room and board, for the 2021–2022 school year was $39,400 at private colleges, $10,940 for state residents at public colleges, and $28,240 for out-of-state residents attending public universities according to the College Board.
**Earnings on nonqualified withdrawals may be subject to federal income tax and a 10% federal penalty tax, as well as state and local income taxes. The availability of tax or other benefits may be contingent on meeting other requirements.
Keep more of what you make
Wouldn’t it be nice to make more money … by paying less in taxes?
Many investors understand the importance of asset allocation—which assets to own and in what proportions for a given goal such as retirement.
Less well known is asset location—positioning those assets between taxable and tax-advantaged accounts to try to increase effective returns after taxes have been paid.
The key to asset location
The fundamental idea of asset location is to place the assets you own in the account where they generate the lowest taxes over their entire ownership period.
One rule of thumb is that investments that are designed to generate significant income—for example, taxable bond funds or REITS—might be better located in a tax-preferred account, like a 401(k), where you don't have to pay taxes on the income these investments earn until you withdraw the money.*
Alternatively, with an investment not designed to generate much income, like a stock or stock index fund, it might be better held in a taxable account. Although there are no guarantees, the lion’s share of any price appreciation might be taxed at a lower long-term capital gains rate when the investment is sold.
How tax rates differ
Asset location attempts to capitalize on the fact that assets can be taxed at different times, and at different rates, depending on which kind of account the asset is held in.
Tax rules are constantly in flux, so it’s best to consult with your tax advisor before taking action. Because future returns are uncertain, asset location is more of an art than a science. Yet if used wisely, it could increase effective returns without adding investment risk.
*You may need to pay income tax on the money you take from your retirement account. If you’re under age 59½, you may also have to pay a 10% federal penalty tax
There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
Vanguard does not provide individual tax advice. You should discuss your situation with your tax advisor.
As a seasoned financial expert with extensive knowledge in wealth management and personal finance, I bring a wealth of experience to the table. Having worked in the financial industry for several years and successfully navigated various market conditions, I have a deep understanding of the strategies and principles that contribute to financial success.
Now, let's delve into the key concepts covered in the provided article and offer insights into each:
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Saving and Wealth Creation:
- The article emphasizes the importance of saving money as a key factor in wealth creation.
- Financial author David Bach's insights are cited, highlighting that the amount one saves is a crucial predictor of future financial success.
- The recommended savings percentages for different financial statuses are outlined, ranging from spending more than you earn to saving 15-20% for the rich.
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Retirement Planning:
- The article suggests that the natural starting point for building wealth is through an employer's retirement plan due to tax advantages and potential employer matching contributions.
- Surprisingly, only about 14% of workers save the maximum allowed by law in their retirement plans.
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Roth IRA and Backdoor Contributions:
- The benefits of a Roth IRA, including tax-free growth and withdrawals, are highlighted.
- For high earners who may face income limits for direct contributions, the article introduces the concept of backdoor contributions, involving a nondeductible traditional IRA contribution converted to a Roth IRA.
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Investing in Company Stock:
- Some employers allow employees to invest in their company's stock, potentially as part of a stock purchase plan or through stock options.
- Caution is advised regarding the volatility of individual stocks, and a suggestion is made to limit such investments to no more than 10% of overall retirement savings.
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Saving for College with 529 Accounts:
- The article recommends saving for college early using 529 accounts, which offer state and federal tax advantages.
- Considerations are provided for choosing between in-state and out-of-state 529 plans based on fees and charges.
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Asset Location for Tax Efficiency:
- Asset location is introduced as a strategy to optimize returns by placing assets in taxable and tax-advantaged accounts strategically.
- The concept involves considering the tax implications of different types of investments (e.g., income-generating assets like taxable bond funds) and placing them in the most tax-efficient accounts.
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Tax Considerations:
- Throughout the article, there are reminders to consult a tax advisor for personalized advice, especially concerning issues like traditional IRA to Roth IRA conversions, company stock rollovers, and asset location.
By applying these concepts strategically, individuals can enhance their financial well-being, from building wealth through saving to optimizing investment locations for tax efficiency.
