2016 Tax Plan (And 2015 Optimizing)

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:

  1. 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.
  2. 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!

14 thoughts on “2016 Tax Plan (And 2015 Optimizing)

  1. Fervent Finance

    I need to get on the self-employment train so that I can contribute more than $18k to my 401k. My tax advantaged savings will look exactly the same as this year: max out Roth IRA, HSA, and traditional 401k. Too bad the limits didn’t increase for 2016 🙁

    1. The Vagabond Post author

      Yeah, it’s a bummer… think we’ve got a good shot at the limits going up in 2017. 🙂 I don’t even know what I’d do without the Solo 401(k). It’s by that tool alone that we have a shot at being done by 40, since I screwed around so much in my 20s. I’m starting to get good at explaining to potential clients that no, really, I really really don’t want to be a W2 employee!

  2. Maggie

    Our planning is a lot less complicated since we make a lot less money! But on the flip side, we’re not yet maxing out my husband’s 401k though we are maxing out both of our Roths. We’ll get there… a little at a time over the next year, I hope!

    1. The Vagabond Post author

      If it helps at all, I will have to find some other sources of income to be able to achieve the plan- I made a loan a few years ago that I hope will be paid back this year, and I’m planning for that. Otherwise, I’ll just adapt!

  3. Matt

    Thanks for the awesome nudge to get my tax plan in order! Doing all my yearly benefit elections at work this weekend, so this is very timely.

    On the HSA, where did you find that you can withdraw after 59.5 for any purpose, tax-free ? Everything I could find says that after ~65~ you just don’t pay the penalty, but that all non-medical withdrawals are taxed:

    > Withdrawals for other purposes are taxed at your full tax rate, with an extra 20% penalty. The penalty is waived if you are at least 65 or disabled…

    > Like a Traditional IRA, your contributions to the HSA are pre-tax contributions and your contributions are allowed to grow tax free. If you don’t use your HSA funds for medical expenses, you can begin withdrawing money from your HSA account for any expenses after you turn 65, without penalty. Like a Traditional IRA, you’ll have to pay income tax on any distributions that aren’t for qualified medical expenses but you won’t incur any additional penalties or fees. Therefore, after the age of 65, an HSA is nearly identical to a Traditional IRA!

    > After age 65, you can withdraw money for nonmedical expenses without owing a tax penalty. (Those withdrawals are taxed as income, as with traditional IRAs.)

    > Funds can be withdrawn for any reason, but withdrawals that are not for documented qualified medical expenses are subject to income taxes and a 20% penalty. The 20% tax penalty is waived for persons who have reached the age of 65 or have become disabled at the time of the withdrawal. Then, only income tax is paid on the withdrawal and, in effect, the account has grown tax deferred (similar to an IRA).

    If this is correct, does this change your strategy?

    No matter what, it lowers your federal AGI (via tax deduction or pre-tax payroll deduction) upon initial contribution. That’s awesome, and may be enough to make the decision to do this.

    On the withdrawal side, I guess it depends on what you expect your medical expenses to be. If you expect them to be high over your lifetime (especially in retirement), of course it makes sense since the initial contributions lower your AGI & withdrawals for medical expenses are tax free. If not, and you are planning this only for retirement (non-medical) withdrawals, it’s not as clear. In this case, if you are choosing between the HSA and other retirement plans, you might do better elsewhere (such as the Roth IRA which is not tax-deductible now, but grows tax free). However if you are maxing out all your other retirement plans then the withdrawals on the HSA aren’t any worse financially than investing outside in stocks/etc which you’d have to pay taxes on anyway. The only downside is you’re locked in until 65 (if you don’t want to pay the 20% penalty).

    Sounds like you should definitely do it if:
    – You know for sure you will have enough medical expenses over your lifetime to use it.
    – You’ve maxed out your other retirement plans and still want to put more away.
    – You have the discipline & financial ability to leave it until 65.

    Does that make sense?

    1. The Vagabond Post author

      Hi Matt,

      Thanks so much for the extensive comment! I actually corrected it to 65 sometime yesterday when I re-read the post (your brain gets so used to writing 59.5 when talking about retirement topics that sometimes it short-circuits!). I am guessing that you had the post pulled up and were working on this response before I made the change. You’re absolutely right, HSA withdrawals are after 65.

      Basically, for my purposes, I’m only really looking at 3-4 years max of being able to save to an HSA before early retirement, and I’m certain that I’ll be able to come up with ~$13K + gains worth of medical expenses in the course of a (hopefully!) 40-50 year retirement, especially given the fact that we are hoping to spend a lot of it abroad where we will likely pay for medical expenses as they arise, in cash. failing that, I’m confident that we’ll have the fortitude to just make it our “last out” retirement money if it came to that (but if we get there, we have much bigger problems!).

      Again, I really appreciate your correction and keeping me honest! I also really appreciate the time you put in to your comment. You rock!

      1. Matt22207

        Thanks! I elected for the maximum HSA contribution this year! Let’s hope it grows (but let’s all hope we actually don’t need medical expenses! ).

        Next up, get my traditional IRA converted to Roth and get working on a Backdoor Roth IRA. Here comes a big tax bill ! Need to figure out if it is better to pay the tax now, or wait the 3-4 years until I hopefully retire (and have a lower tax bill on the conversion) and let the tax-free growth start there.

  4. Pingback: November 2015 Financial Statement - The Frugal Vagabond

  5. Mr. Enchumbao

    Cheers to more investment strategies for 2016! We’ll continue to max out our 401(k)s and saving in CDs the money needed for our first 5 years after early retirement. We’re done in less than 3 years regardless of what happens in the stock market.

    1. The Vagabond Post author

      Nice! We’re probably four years out, but three years from now is about when I anticipate hitting the “I think we’ve probably got enough…” mark. I think I’m more at risk for One LESS Year syndrome!

  6. Rockstache

    I know this is a little old and I am sorry for the necroposting. I had a quick question about your sentence, “I’m not eligible for a Roth or Traditional IRA because of my income level.” If I understand things correctly, what you mean is actually that you are not eligible for the deductions from a tIRA?

    I didn’t realize there was an income limit on contributions, if that is indeed the case. I may need to worry about this in the next year or so. Good problem to have obviously, but taxes are so complicated, I want to make sure I don’t end up getting myself in trouble!

    1. The Vagabond Post author

      Hey Rockstache,

      You’re right, that could have been a little clearer. Yeah, I’m not eligible for deductions from the Traditional, and can’t contribute directly to the Roth. The only option available to me is a backdoor Roth by making a non-deductible contribution to a tIRA and rolling immediately into a Roth. I did that last year. I probably won’t have the surplus to do it this year, but if I can get some more passive income streams going, I might be able to next year.

      You’re right, this stuff is complicated, but it definitely benefits those willing to take the time to learn it!

      1. Rockstache

        Great, thanks for the response! I’m relieved to know I was reading the IRS page correctly. I definitely agree with you on taking time to learn.

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