Is Income a Missing Component to Securing Your Financial Independence?
The old adage, “it’s not about how much you make, but how much you keep…” is often applied to the concept of spending and saving prudently. But, what if spending wisely and prudently managing your savings was just a part of securing your path to financial independence?
Make no mistake, managing your cash flows is essential to mastering your path to financial independence. That’s because without a firm grasp of this critical process, having the money you need to accomplish your life goals likely just won’t happen.
However, maximizing your take-home pay is another essential financial planning task often overlooked by many individuals.
Indeed, whether you’re still in your earning years or already retired, many individuals, whether their income comes from a paycheck or savings distributions, end up leaving thousands of dollars on the table each year.
So, what are some ways to increase your take-home cash flows?
Well, one way to increase your income is to pay no more tax than necessary.
That’s why it’s vital to have a plan in place to ensure that you take advantage of all the tax savings opportunities available to you while paying yourself first, as you make smart financial decisions from one month to the next.
Maximize Employer Retirement Plan
One of the most advantageous ways to minimize your taxes is to maximize your pre-tax retirement savings contributions to an employer-sponsored plan. That’s because the money contributed to these accounts goes in on a pre-tax basis or before taxes are taken out.
Compared to after-tax contributions, this approach maximizes the amount of money that can grow in your savings over the long term.
For example, let’s assume for a moment that your current employer-sponsored retirement account has $250,000 in it. Then each year, you contribute $20,000 to your account on a pre-tax basis that earns 6% annually. At the end of ten years, your portfolio could have grown to $730,000 when making pre-tax contributions.
Now, let’s assume for a moment that you made those same contributions on an after-tax basis. Assuming an effective tax rate of 30%, this time around, you’ll only be able to contribute $14,000 after Uncle Sam gets his fair share of your income. Using the same assumptions as before, at the end of ten years, you’d likely have saved around $650,000.
That’s a difference of $80,000 just by making a simple choice to prioritize pre-tax versus after-tax contributions. And keep in mind that this difference could be even larger if your employer offers matching contributions to your employer-sponsored plan.
Now, some individuals will set aside some money to their 401k or 403b and then make additional contributions to their IRA, hoping to get an extra tax break. The issue here is that if you’re not maxing out your 401k before your IRA, you’re likely only getting a fraction of the tax benefit compared to prioritizing all of your contributions on a pre-tax basis.
This is especially the case for high-earning households, as the tax deductibility of IRA contributions is phased out over certain income limits. In contrast, 401k contributions are only limited by the annual amount you can put in, making them a no-brainer choice when it comes to tax-advantaged savings options.
Create Your Own Retirement Plan
Now, for those of you out there who are self-employed or running a small business and maxing out IRA contributions, consider setting up your own employer-sponsored retirement savings plan. While the thought of setting up your own retirement plan can seem onerous, there are straightforward options available that would allow you to make tax-advantaged contributions.
For example, if you’re relying on an IRA to fund your retirement savings, then you’re missing out on a big opportunity.
For example, options like a Solo 401k, SIMPLE, or SEP IRA allow you to contribute multiples more than an IRA on a tax-advantaged basis and help reduce your overall tax burden. Which one is right for you will come down to the structure of your business. And when it comes to administration, many custodians today make it easy to manage a retirement plan for your business without having to deal with all of the administrative red tape.
Adjust Your W4
Another way to increase your take-home pay is to adjust how much tax is withheld from each paycheck. This approach may be more relevant if you receive a tax refund from one year to the next. Remember, while a refund may seem like a windfall when you receive it, at the end of the day, it’s an interest-free loan that you’re making to Uncle Sam throughout the course of the year.
To this point, to reduce your odds of a tax refund and increase the amount of cash available to you each pay period, you’ll want to adjust your withholding exemptions through form W4. By lowering your exemptions, you can reduce how much money is withheld from your paycheck. Now, before you go out and begin changing your exemptions willy-nilly, be sure to check out the IRS’s Tax Withholding Estimator.
This tool will help you get a gauge the ideal number of withholdings to elect on your W4. And when you’re ready to make adjustments, be sure to reach out to your HR department or your payroll services provider to make the necessary adjustments.
Maximize Your Equity Compensation
Now, for you tech professionals out there, you’ll likely receive incentive compensation in the form of stock options or restricted stock units (RSUs) as part of your total pay package. However, many tech professionals do not fully understand the value and potential of their equity compensation benefits, which can result in missed financial opportunities.
So, if you are the recipient of equity compensation, what are some things you should watch out for to maximize your income?
First, you’ll need to understand that equity compensation is tied to your company’s overall performance and can increase in value over time as your company grows and its stock price rises. If you’re a tech professional who receives equity compensation and yet you’re not paying attention to the details of your equity award, you may miss out on the opportunity to sell your stock at a higher price, potentially resulting in a significant financial loss.
Second, there may be restrictions or deadlines associated with equity compensation that you may need to be aware of. For example, RSUs typically vest over a period of time and may be subject to forfeiture if you leave your company before the vesting period is over. Stock options, like ISOs may also have expiration dates, meaning that they become worthless after a period of time. So staying on top of those vesting periods is essential.
Third, tax implications of equity compensation should also be considered. Tech professionals need to understand the tax implications of exercising stock options or selling RSUs, such as ordinary income tax on the difference between the exercise price and the stock price at the time of exercise, as well as potential capital gains tax on the sale of the stock.
Now, it’s easy to leave your stock award aside and do nothing with it. That’s why you’ll likely benefit from last month’s discussion on equity compensation housekeeping. You can find resources in the FI|Mastery Journey to review best practices for managing your awards. But at the very least, get to know your equity award and check to make sure that you’re taking advantage of opportunities where they’re available.
Pre-tax Spending Needs
Another effective way to maximize your income is to pay for regular expenses on a pre-tax basis. A couple of tools available through your employer may include health savings accounts, or HSAs, and Flexible Spending Accounts, or FSAs.
If you have a high deductible health plan (HDHP), for example, HSAs allow you to make pre-tax contributions that can be later used to pay for medical expenses. This account type also has an investment component built into it that allows your savings to grow over the long term.
Another way to spend on a pre-tax basis is to utilize a Flexible Spending Account or FSA. These accounts are typically a use-it-or-lose-it type of account. And this means that any contribution you make during the course of the year must be spent, or you’ll lose that money by the end of the year.
Even so, these types of accounts still offer some advantages.
For example, let’s assume for a moment that you spend $10,000 per year on childcare expenses. If your employer offers a dependent care FSA, a household is allowed to contribute $5,000 annually to this account on a pre-tax basis. Assuming that your effective tax rate is 24%, your $5,000 gives you a savings of $1,500 annually on that contribution towards your childcare expenses that you may have otherwise paid for on an after-tax basis.
Review Your Employer’s Group Life Coverage
Another way to keep more money in your pocket is to evaluate how you’re paying for life insurance. Now, whether you have a family or are just getting started, life insurance is often a cheap way to transfer financial risk should something happen to you.
And if you have an individual life insurance policy but are not taking advantage of your employer’s group policy, you may be paying more for that individual policy than what’s available to you through your employer’s group benefit.
Renegotiating Your Pay
Finally, consider asking your employer or clients for more money. This may include having an awkward conversation that could end up netting you a few extra thousand dollars per year. This approach could involve either asking for raise or negotiating an off-cycle increase in your incentive compensation, such as a bonus or off-cycle equity grant.
And if you’re self-employed, now may be the time to evaluate the fees charged to your clients. Given the recent cost of living increases, now may be an opportune time to raise your prices to reflect the value of your services and rising overhead costs.
Increasing the take-home income component of your cash flows can help ensure that you achieve your spending and savings goals for the year. While earning more money is certainly one way to accomplish these goals, being more tax-efficient with your cash flows is a more controllable approach to bringing home more money from one pay period to the next.
Maximize Your Post-Employment Income
Now, if you’ve already achieved your financial independence goals and are living off retirement savings, then finding ways to maximize your take-home salary may seem less relevant to you.
Even so, while fine-tuning your earnings ability was a key consideration during your accumulation years, focusing on the income-producing capabilities of your savings nest egg will be essential to staying strong financially in retirement.
Now, while some rules of thumb will guide you on how much you should safely withdraw from your portfolio from one year to the next, the fact is that a disciplined investment process will be essential to preserving the value of your potential lifetime retirement income.
To this end, there are two approaches you should consider when it comes to maximizing the potential retirement income generated by your investment portfolio this year: 1) your investment strategy and 2) your cash management strategy.
Let’s take a look at how ways you can maximize the income-producing ability of your retirement savings:
Diversify Your Investments
First, one of the most important steps you can take to maximize the sustainable income from your investment portfolio is to diversify your investments. To do this, ensure that you’re spreading your assets across various types of investments, including stocks and bonds, US and international investment assets. This approach will help reduce your portfolio’s overall risk and ensure a reliable income stream throughout your retirement.
Indeed, setting an appropriate mix of stocks and bonds, US and international assets, is essential for preserving the income-producing capabilities of your retirement savings. And the degree to which you allocate between various asset classes influences your investment rate of return.
For example, a larger allocation to historically riskier assets could generate a higher rate of return for your investment portfolio compared to allocations to typically conservative assets like government bonds.
So, how much should you contribute to each mix? Well, start by evaluating your risk tolerance and preparing your investment policy statement to find the right mix for you. This approach will be essential to crafting and sticking to a disciplined investment process in the years ahead.
Consider Passive Investment Strategies
Next, consider allocating your savings to passive investment strategies, such as exchange-traded index funds (or ETFs). These vehicles are often lower cost and easier to manage than actively managed portfolios. This can help you maximize the income from your investment portfolio by reducing the amount of money you need to spend on fees and expenses.
Consider Tax-Efficient Sources of Income
Another way to maximize the income from your investment portfolio involves understanding how that income is taxed. For example, capital gains, dividends, and interest income can all be taxed at different rates. Therefore, if your portfolio composition, or the allocation to a particular security or asset class, is heavily weighted towards taxable income, you could be giving away more of your income to Uncle Sam than necessary.
Therefore, one way to produce tax-efficient income for your portfolio is through munis. Municipal bonds, also known as munis, are debt securities issued by state or local governments to finance public projects such as infrastructure, schools, and hospitals.
In a retirement investment portfolio, municipal bonds can serve as a source of stable, tax-free income. Since the interest earned on munis is often exempt from federal and state taxes, they can be especially attractive for individuals in higher tax brackets who are looking for ways to reduce their tax liability.
Munis can also add diversification to a portfolio, as their performance is often uncorrelated with stocks and other bonds. However, it’s essential to consider the credit risk of the issuer, as well as the market risks associated with bonds, before adding munis to a retirement portfolio.
Reduce Your Future Tax Liability
Another way to increase your retirement income is by reducing how much tax you’re paying to Uncle Sam. To achieve this outcome, you’ll want to evaluate the tax efficiency of your portfolio. If you expect your taxable income to rise after retirement, especially when required minimum distributions (or RMDs) kick in, consider ways to reduce your future tax liability.
In some cases, evaluating the benefit of a Roth Conversion might make sense. A Roth conversion is the process of moving money from a traditional individual retirement account (IRA) to a Roth IRA. By converting a traditional IRA to a Roth IRA, a retired individual may be able to reduce their future tax liabilities by establishing a source of tax-free withdrawals, reducing or eliminating RMDs, and generally putting them in a lower overall tax bracket.
Rebalance Your Portfolio Regularly
Another way to maximize income over the long-term is to potentially mitigate near-term losses in your portfolio through regular rebalancing. As markets fluctuate, your portfolio’s asset allocation may change, which can impact the sustainable withdrawal rate you can generate from your investments. To avoid this, consider rebalancing your portfolio regularly to ensure that your desired asset allocation is maintained.
Consider Inflation-Protected Investments
Now, if you’re reliant on your retirement savings to cover your living expenses, you’ll need to be mindful of the effects of inflation. Inflation is a natural part of the economy, but over time it can erode the purchasing power of your investment portfolio. To combat this, consider whether investing in inflation-protected investments, such as Treasury Inflation-Protected Securities (TIPS), can help preserve your purchasing power over the long term.
Have an Adequate Cash Management Plan
And finally, another critical component to preserving your spending ability when drawing down assets is having an adequate cash management plan in place. This means having enough cash on hand within your portfolio to cover 12-18 months’ worth of living expenses.
Why so much cash on hand?
Well, after a year like 2022 in the markets, the last thing that you want to be doing is selling securities in a down market to cover your living expenses.
Either way, finding ways to maximize your income from your investment portfolio is vital to ensuring that you don’t go broke in your post-employment years.
Addressing this concern begins by having an investment strategy and mix of assets that fit your overall risk tolerance, goals, and objectives. Then, allocating to low-cost, tax-efficient investments likely will ensure that you’re keeping more of your money by paying only what is necessary.
And finally, have a cash management plan in place may allow you to weather the ups and downs in the markets without having to sell securities at an inopportune time.
Pay Yourself First
Now that we’ve discussed ways to maximize your income, whether that’s from earned income or retirement income, let’s take a few minutes and explore the concept of paying yourself first.
So, what do we mean when we say to pay yourself first?
Well, we’re talking about setting aside a portion of your monthly income for savings and investments before paying bills and spending on other expenses. This approach may help you prioritize your financial goals and build wealth over time.
Paying yourself first includes funding your cash management or emergency savings fund and allocating your money to suitable financial accounts.
How to Pay Yourself First
Now, a cash management or emergency savings fund is an essential component of a solid financial plan. It is a savings account that is set aside for unexpected expenses, such as a car repair, medical bill, or job loss. Indeed, having an emergency savings fund can provide peace of mind and financial security in times of crisis.
Evaluate Your Emergency Savings Target
So, how much should you have saved in your emergency savings fund?
Well, one rule of thumb is saving between 3-6 months of household living expenses. Depending on your situation, your financial planner will define this number for you as part of your specific financial plan. Either way, know your number and commit to it.
In terms of where to save that money, here are some options:
High-yield Savings Account
A high-yield savings account is a type of savings account that offers a higher interest rate than a traditional savings account. This means that your money will grow faster, and you will earn more interest over time.
Certificates of Deposit (CD)
A CD is a type of savings account that allows you to deposit money for a fixed period, typically from 3 months to 5 years. CDs usually offer a higher interest rate than savings accounts, but they also have penalties for early withdrawal.
Roth IRA is a type of retirement account that allows you to invest money after tax, and withdrawals in retirement are tax-free. If you are young and in a low tax bracket, this might be a good option to consider.
Whichever account type you choose to leverage as your savings vehicle, it’s always worth considering some best practices to maximize your emergency savings.
Order of Savings Operations
Now that we’ve talked about ways to fund your emergency savings, where should your money go when it comes to longer-term savings?
Make no mistake, it can be confusing to know which accounts to contribute to first and in what order. As you begin paying yourself, you should contribute to various retirement and taxable investment accounts that give you the most significant tax bang for your buck.
Employer-sponsored retirement plans
The first step in saving for retirement should be taking advantage of your employer-sponsored retirement plan, such as a 401(k) or 403(b) plan. These plans offer significant tax benefits, including the ability to contribute pre-tax dollars. Additionally, many employers provide matching contributions, which is free money and a 100% return on your retirement contributions.
After you have maximized your contributions to your employer-sponsored retirement plan, you should consider contributing to an individual retirement account (IRA). Traditional IRA contributions are tax-deductible, and the money grows tax-free until withdrawal. Roth IRA contributions are made with after-tax dollars, but withdrawals in retirement are tax-free.
Taxable Investment Accounts
Once you have maximized your contributions to your employer-sponsored retirement plan and your IRA, you can begin contributing to taxable investment accounts. These are investment accounts that are not tax-advantaged, such as a regular brokerage account. The benefit of these accounts is that you can withdraw money at any time without penalty.
Health Savings Account (HSA)
If you are enrolled in a high-deductible health plan, you may be able to open a Health Savings Account (HSA). The benefit of these types of accounts is that contributions to an HSA are typically made on a pre-tax basis, the money grows tax-free, and withdrawals for qualified medical expenses are also tax-free.
College Savings Plan
And if you have children, consider contributing to a college savings plan, such as a 529 plan. These plans offer some tax benefits including the ability to take tax-free withdrawals for qualified education expenses.
Now, it’s important to note that some of these accounts have contribution limits, and it’s essential to check the limits and rules to avoid penalties. Additionally, you should consider your overall financial situation and goals when deciding how much to contribute to each account.
Ultimately, the most important thing is to find an account that works for you, that you are comfortable with, and that you can access easily in case of emergency.
Setting up a savings plan, tracking your spending and cutting back on unnecessary expenses are all effective ways to build an emergency savings fund. Remember, it’s never too late to start building your emergency savings fund, which is necessary to achieve financial stability.
The Missing Component to Achieving Financial Independence: Maximize Your Income
By taking steps like maximizing pre-tax retirement contributions, creating a self-employed retirement plan, and adjusting your W4, you can minimize your tax burden and in many cases maximize your income.
And the result is more money in your pockets and a secure financial future.
But it doesn’t stop there. Maximizing the income from your investment portfolios is crucial for a strong and sustainable retirement. Diversifying our investments across stocks, bonds, US and international assets, and allocating your savings to passive investment strategies like index funds, can reduce overall portfolio risk and increase your retirement income. Plus, by finding tax-efficient sources of income, reducing future tax liabilities, and investing in inflation-protected investments, you can take control of our financial future.
But it all starts with a disciplined investment process, a deep understanding of the tax implications of your portfolios, and a careful consideration of all the factors that impact your retirement income. With the right strategies in place, financial independence is well within your reach.
Finally, the key to maximizing your income is to avoid letting it be diverted to the inevitable financial setback. By establishing a solid cash management or emergency fund, you can secure your financial stability in times of crisis. Whether it’s through a high-yield savings account, CD, Roth IRA, or other options, the key is to evaluate our emergency savings target, choose the right savings vehicle, and contribute to it regularly.
The sacrifices may be temporary, but the peace of mind and financial security will last a lifetime. Indeed, taking theses steps will not only allow you to maximize your income, but they’ll also take get you one step close to becoming the master of your own financial independence journey.
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