How valuable is each dollar you receive?
It depends how you receive that dollar. A dollar that is “gifted” to us is more valuable than a dollar of wages paid to us. Why? Because a dollar in wage must be taxed first, leaving us with less than a dollar.
There’s a whole “hierarchy of money” that looks something like this:
- FREE Money – inheritance, lottery winnings, employer matching funds
- Tax-Free Money – Tax-free Bonds, Roth IRAs, Cash Value Life Insurance
- Tax-Deferred Money – Contributions to a 401k, IRA, or other qualified plan
- Taxable Money – Wage/business income, interest, dividends, capital gains.
Free money is tough to come by – except in the case of company matching funds in a 401k, 403b, or other tax qualified plan. But many of us get tripped up by “over-contributing” to these plans in a way that violates the hierarchy.
Here’s what I mean. While yours might vary, a common employer contribution limit might be, “50% of employee contributions up to 5%.” This mean that a 10% saver receives no matching funds on their last 5% – even though saving (at least) 10% is a wise and prudent thing to do.
So by saving 10% – that last 5% is tax-deferred – skipping the more valuable “tax-free” category altogether. The “fix” isn’t difficult – just re-direct that 5% to a tax-free vehicle – the two most common of which are the Roth IRA and cash value life insurance.
While either are better options than any tax-deferred alternative, I prefer the life insurance route because 1) you have to have some anyway, and 2) you can eliminate principal risk with the right kind of life insurance. In other words – you kill three birds with one stone; tax-free, risk-free, and a death benefit.
The Roth may allow a wider range of investment options, but remember – like it’s traditional IRA counterpart – a penalty applies to pre-retirement withdrawals.
Yes – either will require you to pay tax on the income today – meaning you’ll be saving less – but the math will almost always show that paying tax on the seed today – is much better than paying tax on the harvest tomorrow. Just ask a farmer. Besides – what do you think tax-rates might be by the time you get around to paying them?