I’m not going to lie, being financially independent is nice. It enables choice and opportunity. We can choose to earn an income, or not. We can choose to remain in one location, or not. We can pretty much choose to do anything we want, when we want, and how we want.
In fact, I’m pretty sure there is only one thing better than being financially independent: Being financially independent SOONER!
How would you like to accelerate your savings, becoming financially independent years ahead of schedule? What if you could do this without saving even 1 extra dollar? Not one!
Let’s Turbocharge your Savings!
All you have to do is put every penny you can into tax-deductible accounts: A Traditional 401k, an HSA, a Traditional IRA. But what about the Roth 401k or Roth IRA? No! Not now, not ever. I’ll explain
First we need to understand a little about how money disappears from your paycheck in the form of income taxes. Yes, taxes are boring. So instead of reading those horrible IRS documents we are going to look at some pretty pictures with bright colors. Just like going to the museum
Let’s check out a Picasso, often simple, yet difficult to understand without the tour guide’s explanation.
That pretty red line is the taxes paid in 1 year for different levels of earned income. See how the tax on the first $20,000 of income for a Married couple filing jointly is $0? As income increases to the right, the red line slopes upward representing more tax paid
The first ~$20k is taxed at 0%, the next ~$20k is taxed at 10%, the next ~$50k is taxed at 15%, and so on. The gradual increase in tax rate is known as marginal taxation, a fancy way of saying that the next dollar you earn is taxed more heavily than the previous dollar
At ~$200k of income, the 95th percentile of US families, the marginal rate (Blue line) is 28%. But the effective tax rate (Green line) is much lower. Even though the last dollar is taxed at 28%, the average tax rate on all dollars is less than 19%.
And that, in a nutshell, is the US Income Tax system for everybody with a job.
If you only remember a few things from the tour guide’s speech, remember this.
- A married couple doesn’t pay much tax on the first $40k of income
- 95% of income earners (<$200k/year) pay less than a 20% effective tax rate
If that isn’t clear, you can get a refund on the price of admission. Submit your refund request in the comments
Tax Deductible Savings
The government doesn’t want a lot of destitute senior citizens subsisting on cat food and refusing to turn on their AC during heat waves. Starving and dying people are bad press. It’s also bad for the economy, which probably concerns the politicians more.
For these reasons, the tax laws encourage saving and investing in the form of 401ks and IRAs
In 2014, an individual could save up to $17,500 in a 401k tax-free. A married couple with two workers could save 2x that amount.
Back to the pictures. Let’s check out a Seurat. It even has dots
Contributing to a 401k effectively shifts our tax curve. More dollars are taxed at 0%, resulting in less tax paid. For a married couple, when one of them contributes the maximum to a 401k, the first ~$40k of family income is now tax free. If both contribute the max, the first ~$55k is tax free
Other tax deferred accounts, such as an HSA, can shift the curve further, as can itemizing deductions for some people
The reduction in tax is substantial! Thousands of extra dollars are saved
More Free Money!
But it gets even better! Employers don’t want the IRS to have an exclusive on reducing the nation’s quantity of distressed Seniors. On average, US employers contribute 2.7% of salary to a 401k, but only if you contribute.
By contributing the maximum amount to a 401k, we can reduce our taxable income by $17,500 AND get a 2.7% tax free increase in pay. And this is just for saving, something we were going to do anyway
Three different working families, one at the median income level (50th percentile), another at the 75th percentile, and one more at the 90th percentile, all aspire for early retirement and have committed to saving 50% of their paychecks. This represents the majority of people surveyed expressing interest in pursuing Financial Independence. Below the median level, a focus on increasing income is also necessary
Before you get your knickers in a bunch, consider that many are already saving 50% or MORE
- We did it for 10 years
- Joe Udo of Retire by 40 does it
- Mr and Mrs Frugalwoods are doing it, and then some
- Jason Fieber of Dividend Mantra has done it for years
- Justin of Root of Good did it
- Mr Money Mustache did it, and continues to save more than 50% even after retirement
For each income level, let’s compare saving in a brokerage account vs. savings in a 401k. I promised pretty pictures…
The families that contribute to the 401k are able to save approximately 20% more! The higher the income, the better the immediate return by using a tax-deductible account
In a brokerage account, saving 50% of income it is possible to be financially independent in 16 years. Using a 401k, it is possible in 13 years! You just won back 3 years of your life!
Since it only takes 30 seconds to sign up for a 401k, that is like earning a quadrillion dollars an hour. What other activity has that kind of return?
Go ahead and do it now. I’ll wait
While you are at it, try a FREE 401k Health Check from Personal Capital
But… what about the Roth?
There are a few common myths about Roth 401k/IRA “advantages”:
- Tax wise, a Roth and Traditional IRA or 401k are basically the same thing
- Roths are good for the very young or very low income earners
- A Roth allows penalty free access to funds before Age 59.5
- A Roth is good if you expect taxes to rise or your post-retirement tax rate to be higher than today
But none of these hold up to close scrutiny
Think about it this way. When we invest $1 in an IRA, that dollar is the last dollar we earned. It is taxed at our highest marginal rate. But when we withdraw $1 from our IRA years from now, it is our First Dollar. As we saw in the pretty pictures earlier, the First Dollar is always taxed at 0%. Take the tax savings now, and Turbocharge Your Savings!
(Yes, as with any good rule (or law) there are exceptions. See why the Roth is last on our preferred list of investments when we discuss The Great Roth Controversy)
The Go Curry Cracker Way
What did we do during our working years? We Turbocharged our Savings by putting every penny we could into a 401k and HSA
As seen above in the Van Gogh picture, when saving a high percentage of income, it is inevitable that you also build savings in a taxable/brokerage account.
When a 401k and Brokerage account are combined with a powerful tax strategy and a small cash buffer, it is possible to become financially independent in the fastest possible time with the largest possible nest egg.
In this way, we built up passive income streams from dividends and interest, in our 401k and Brokerage accounts, both.
Want to become Financially Independent in record time?
Maximize your contributions to pre-tax accounts like the 401k, Traditional IRA, and HSA. Taking advantage of all available tax reductions will accelerate your success. This is how you Turbocharge Your Savings!
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