4 Tax-Advantaged Accounts Gen Z Needs to Master for Early Retirement and Passive Income Success

Hey there, Individual Investor!

I've been thinking about financial freedom and early retirement a lot lately. 

And Gen Z faces unique challenges in building wealth and securing their future.

The traditional path of working until 65 and relying on Social Security is becoming obsolete. Many young adults find themselves overwhelmed by student debt, rising living costs, and a job market that's more volatile than ever. The idea of early retirement or achieving financial independence can seem like a distant dream.

Typical financial advice often focuses on budgeting and cutting expenses, but these methods alone are insufficient for building long-term wealth and achieving early retirement.

Thankfully you have available to you a secret weapon in personal finance. 

It's called a tax-advantaged account. 

Tax-Advantaged Accounts: Your Secret Weapon for Financial Freedom 

Without the advent of tax-advantaged accounts, it might be near impossible to achieve financial independence for the average individual investor. 

I stumbled on these by accident early in my career and I'm glad I did. 

Taxes can take a huge chunk out of the future earnings of your income, so it's super important to minimize their impact as much as possible. If you're not a money nerd yet (I will convert you), this is how you become one.

Learning how to optimize tax advantaged accounts might sound boring, but it will save and make you a ton of money in your investments. 

Here's how much: 

Let's say you make $100K annually and you want to save, invest 10% of your income and you're hypothetically in the 30% tax bracket. 

If you invest in your employer 401K and get a 4% match, assuming a 10% annual return (100-year average of S&P not inflation adjusted), after 30 years you would have:  $3,154,649.00. 

You would have contributed:  $475,754.00. 

Your employer matched: $190,302.00

Your total investment returns would be: $2,488,594.00.

Image below generated by my favorite free financial calculator website www.calculator.net.

Taxable Account Difference

Now, if instead you invested in a taxable account $10,000 annually, you would have to pay 30% in taxes before you invested it and you wouldn't get the employer match, so you would only be able to invest $7,000. 

That $7,000 growing at 10% annually would be worth: $893,968.00 

Your contributions: $333,027.00

Total Earning (After Tax): $560,941.00 

What's the difference you say? 

By investing in the 401K: You end up with $2,260,681.00 More Money!

Optimal Order of Investments in Tax-Advantaged Accounts

Now that you understand the power of the tax advantaged accounts, let's look at the optimal order of investments in the different tax-advantaged accounts available to you. 

Here are four tax-advantaged accounts that Gen Z needs to master for early retirement and passive income success:

1. 401(k) with Employer Match: Contrary to popular belief, this isn't free money. If your employer offers this, it's part of your compensation package and if you don't use it, then you're leaving money on the table. If your employer offers a 401(k) match, contribute at least enough to get the full match. For example, if your company matches 50% of your contributions up to 6% of your salary, contribute 6% to get the full 3% match. This instantly boosts your savings by 50%.
2. Health Savings Account (HSA): Often overlooked, HSAs offer triple tax advantages. Enroll in a high-deductible health plan to qualify for an HSA. Contribute pre-tax dollars, invest the funds for tax-free growth, and make tax-free withdrawals for qualified medical expenses. After age 65, you can withdraw funds for any purpose without penalty, paying only income tax on non-medical withdrawals.
3. Roth IRA: This account offers tax-free growth and withdrawals in retirement. This means that you don't pay any taxes on withdrawals in retirement. Start by opening a Roth IRA with a reputable broker. Contribute up to the annual limit ($7,000 for 2024 if you're under 50). Invest in low-cost index funds or ETFs for long-term growth. Remember, you can withdraw contributions (but not earnings) tax and penalty-free at any time, making this account flexible for Gen Z's changing needs.
4. Traditional IRA: If you don't income qualify for a ROTH IRA, then you should contribute to a Traditional IRA. With the traditional, you can take the upfront tax deduction on the contributions and your earnings still grow tax deferred. Bonus: If you plan to retire early, then there are distinct advantages investing in a Traditional over a Roth since you can later convert to a ROTH and avoid the 10% withdrawal penalty. This is called a Roth Conversion Ladder (more on this in another newsletter).  
5. Bonus Backdoor Roth IRA: For high earners who exceed Roth IRA income limits and the income limits for a tax deduction on the traditional, this strategy allows you to still benefit from a Roth. First, contribute to a Traditional IRA. Then, immediately convert those funds to a Roth IRA. Be aware of the pro-rata rule if you have existing Traditional IRA balances. If you don't know what this is, you could get taxed twice. Look it up at Investopedia here.

Example of how this can work for you. 

Let's look at a real-life example. Sarah, a 25-year-old software developer, implements this strategy:

• She maxes out her Roth IRA ($7,000/year)
  • $222,400.00 by age 40.
• Contributes to her HSA ($3,650/year for individual coverage)
  • $135,000 by age 40
• Puts 6% of her $80,000 salary into her 401(k) to get the full 4% match ($4,800 + $3,200 match)
  
  • $314,414.00 by age 40.

In total, Sarah is saving $18,650.00 per year in tax-advantaged accounts. Assuming a 10% annual return, by age 40, she could have over $674,714 saved, giving her a significant head start on early retirement.

Conclusion and Action Steps

By leveraging these tax-advantaged accounts, you can significantly accelerate your path to financial independence. The power of compound interest combined with tax advantages can lead to substantial wealth accumulation over time.

Don't wait to get started. Open these accounts today and begin your journey to financial freedom. The earlier you start, the more time your money has to grow.

Take action now: Research these accounts, determine which ones you're eligible for, and start contributing. Your future self will thank you.

For more information on maximizing your tax-advantaged investing strategy, check out resources like the IRS website for contribution limits and rules, or financial education platforms like Investopedia for in-depth explanations of these accounts.

P.S. I want to hear from you and help you. 

How are your investments doing? 

What are some challenges you're facing when it comes to investing and personal finance. 

Just reply to this email. 

Let's have a conversation.