There are ways to be a tax-efficient W-2 employee.
A list of tax advantages for W-2 workers.
So many employees have this preconceived notion that given they are not a business owner, there is little opportunity to be tax efficient. But this would be a myth. Sure, they may have less optionality relative to their business owner counterparts, yet there are ample avenues to tax efficiency.
Today, I wanted to outline a few different ways in which I see W-2 employees find tax advantages.
401(k)s, 403(b)s, 457(b)s:
The slew of employer sponsored retirement plans. If you’ve been following me, you know the advantages of these accounts. Many allow both pre-tax and Roth contributions and they can be very useful when looking to build up retirement savings. Just note that 457(b) plans can vary depending on whether the plan is governmental or non-governmental.
HSAs:
Health savings accounts are available to those that are enrolled in a qualifying high-deductible health plan. HSAs are arguably the most tax advantaged account out there at the federal level. When they are established as a Section 125 Cafeteria plan, they can even avoid FICA. Contributions are made on a pre-tax basis, the funds grow tax-deferred, and they can be distributed tax-free for qualified medical expenses.
For more information on HSAs check out this old post here!
NQDC (Non-qualified deferred compensation) plans:
These types of plans are usually offered to highly compensated employees at certain companies. An NQDC works similarly to a 401(k), yet it does not have contribution limits. The drawback to these accounts is that they are bound by the same ERISA requirement a 401(k) plan would be and they can be subject to creditors’ claims in the event the company goes belly up. For some highly compensated employees at stable and established companies, the risk of forfeiture is worth the potential reward of deferring taxes!
Tax-loss harvesting and direct indexing:
I’ve written numerous times on the potential tax benefits of tax-loss harvesting as well as how direct indexing can aid in this process.
Losses have economic value! They are asymmetrical as well! Short-term capital gains can be offset by long-term capital losses!
For more TLH and direct indexing coverage, be sure to check out this old post: The evolution of investing.
Asset Location:
Asset location is another avenue to tax-efficiency. Essentially, this is using different types of accounts to hold different assets. For a high level example, a tax-deferred account such as a Traditional IRA or 401(k) may hold assets that have annually taxable components to them (think dividends, interest, etc.). Whereas a Roth IRA, which will hopefully never be subject to tax may be skewed more towards assets that are believed to grow more rapidly given the funds can be distributed entirely free of tax after age 59.5.
Some believe asset location to have too many assumptions around the performance of asset classes. And this is not an invalid argument. But there are nuanced instances in which I have seen asset location move the meter significantly in practice.
These 5 different avenues to tax efficiency can be very helpful to W-2 employees. But it does not stop there. Here’s an additional list for those that are curious:
Mega Backdoor Roth
Strategic Roth conversions
Charitable donations and strategic bunching
Equity compensation planning and holding period advantages
529 Plans that allow for state tax deductions
Employer sponsored commuter benefit plans
While W-2 employees may not have all the potential tax advantages that business owners have, there is still a lot of opportunity to optimize for taxes.
Knowing which solutions are out there is a start. From there, it is all about tailoring the avenues for tax efficiency according to what works for you!
This is for informational purposes only and is not intended as legal, tax, or investment advice or a recommendation of any particular security or strategy. The investment strategy and themes discussed herein may be unsuitable for investors depending on their specific investment objectives and financial situation. Opinions expressed in this commentary reflect subjective judgments of the author based on conditions at the time of publication and are subject to change without notice. Past performance is not indicative of future results.