It may only be November, but that doesn’t mean you can’t start making your 2016 tax plan! Open enrollment for insurance has begun for 2016, and there’s still time to save on taxes for 2015.
Investment Changes for 2015
This week, I saw some opportunities to optimize and made a couple of changes. After maxing out my Individual 401(k) for the year, I had some leftover funds earmarked for investment. Over the course of the year, I had invested the excess into a taxable account, but still had the November and December investments to plan for. I’m not eligible for a Roth or Traditional IRA because of my income level. I knew in the back of my mind that a Backdoor Roth IRA was a possibility for me, but hadn’t ever really explored it in detail.
First off, a discussion on the Roth IRA. One contributes to a Roth IRA with after-tax money, but once it’s there, all gains are completely tax-free. This is preferable to a taxable investment account because in that case, the investments are after-tax, and the gains are taxed as well. If you make enough money ($131,000 a year in 2015), you are ineligible to contribute directly to a Roth IRA.
A Backdoor Roth IRA is a way of getting funds into a Roth even though your income level is too high to qualify. It’s accomplished like this:
- Contribute the maximum possible to a Traditional IRA ($5,500 in 2015). This contribution is after-tax money since our income level is too high to qualify for a pre-tax IRA.
- As soon as the money hits the Traditional IRA account (the next day, in my case), transfer the funds into a Roth IRA.
In a circuitous (but still simple) way, even those with incomes too high to qualify can contribute to a Roth IRA and enjoy tax-free gains. The White Coat Investor has a great tutorial on doing a Backdoor Roth IRA, so I won’t reinvent the wheel here.
One key thing the White Coat Investor mentions is that if you have any other IRAs (SEP IRA, Rollover IRA, traditional IRA, SIMPLE IRA) with a balance, you must dispose of them in some way by the end of the year.
In my case, I had a small ($4,500) Rollover IRA that I needed to dispose of. I chose to convert it to a Roth IRA and pay the taxes. This was a little painful, but it will be worth it in the end for tax-free gains. If I had my Individual 401(k) somewhere that accepts rollovers, I could have rolled the IRA into that plan instead of paying the taxes, but since the amount was so small, I am not worrying about it too much.
Then, I opened a new Traditional IRA at Vanguard and contributed $5,500. When asked where I wanted to invest the money, I chose the “I’m not sure yet” option, which puts the money into a money market account. This is a good move since we want to prevent the contribution from growing at all until it is safely in the Roth IRA.
One day later, I logged back into Vanguard and clicked “Buy and Sell Funds.” From that screen, I chose “exchange funds.” I chose the $5,500 in the Traditional IRA as the funding source, and my VTSMX fund in the Roth IRA as the fund to be purchases, and clicked Submit. Vanguard warns that this may be a taxable event, but since I placed the money into a money market account, it did not grow at all, and thus there is nothing to tax.
2016 Health Insurance Planning
I’m in very good health, and almost never need to see a doctor. I also pay my own insurance as a self-employed person. A few years ago, I read an article at The Mad Fientist explaining the ultimate retirement account: The HSA. The gist of it is this: A person with a high deductible health care plan can contribute pre-tax funds to an HSA account ($3,350 in 2015/2016). Those funds can be invested in normal index funds, and the gains are tax free too. The HSA is literally the only account where both the contributions and the gains are tax-free. In order to take advantage of an HSA, I changed my 2016 plan to a high deductible, HSA-compatible plan.
In theory, these funds must be used to pay for medical expenses. However, this is only until age 65, at which point they can be withdrawn for any purpose! Moreover, HSA funds can be used to pay for vision and dental expenses, including expenses accrued abroad! Since I’m in the midst of my adventure seeking dental treatment abroad, I could use some of these tax-free funds to pay for that treatment.
An even better idea, though, would be to pay for that treatment with cash, and keep ample records. You see, you don’t have to pay for your medical expenses directly with the account. You can also pay in cash, keep receipts, and reimburse yourself at some later date. Thus, I can leave the funds for my 2016 medical treatments in the HSA and allow them to grow tax-free for as long as I wish… or forever!
2016 Tax Plan
Here are the investments I hope to make in 2016 in order to minimize taxes, now and in the future.
- $3,350 HSA
- $53,000 Individual 401(k)
- $5,500 Backdoor Roth IRA (After-tax)
In addition to this, I’m hoping to acquire three more rental properties to grow our semi-passive retirement income.
I’m excited about my 2016 tax plan, and also that I managed to find a few places to further optimize 2015. What about you? Are you making any changes to make 2016 an even better year? Please let me know in the comments!