9 Easy Steps to Building a Great Investing Strategy Using the Tax-Efficient Waterfall
If the thought of starting to build an investing strategy overwhelms you, that’s ok! In fact, that’s totally normal. Nearly all physicians come out of medical school with little to no idea of how to master their personal finances. That’s the main reason I started The Scope of Practice.
Fortunately, there are a lot of great strategies out there to help you go from “financial novice” to “DIY Investor Extraordinaire.” For example, you may be familiar with Dave Ramsey’s Baby Steps if you have taken his Financial Peace University class. That’s a great strategy and has proven effective for millions of people.
Another investing strategy idea is the “tax-efficient waterfall.” The idea with this investing strategy is to utilize a series of investment vehicles to make maximum use of tax-advantaged accounts.
A couple of points about this investing strategy
- This is not the only valid investing strategy. I cut my teeth as a financial coach teaching Dave Ramsey’s principles through Financial Peace University. Some people just invest in their company’s 401(k). The tax-efficient waterfall strategy is highly effective and powerful, but there are certainly other options worth considering.
- Max out each bucket before going to the next one. The idea behind the “waterfall” is that the water cascades from one bucket to the next. So, start with bucket #1. When that’s full, move on to bucket #2, then #3, and so on.
- Many people never make it past bucket #4, and that’s ok! The goal is to maximize tax-efficiency in a step-by-step plan. However far you make it down the list, that’s great!
- This strategy doesn’t include recommendations for college savings, saving for a wedding or other large purchase, or discussion of insurance. This strategy specifically refers to how to attack debt and invest for retirement. It needs to be incorporated into your comprehensive financial plan.
9 step investing strategy: the tax-efficient waterfall
“Step zero”: Have an emergency fund
The need for an emergency fund has never been more obvious than in 2020, as the COVID-19 quarantine wrecked the economy. This particular emergency may never happen again, but you can bet that there will definitely be some sort of need for emergency funds eventually.
Dave Ramsey recommends a $1,000 emergency fund for people that are aggressively paying off debt. That’s fine for people with very little debt that will pay it off in a year or so. But, Dave says (and I agree) that if you have hundreds of thousands of dollars in debt, you should have a beefier emergency fund before starting to pay off debt. This is what I propose as a starter emergency fund for people that are aggressively paying down debt.
Debt level Time to pay off debt Emergency fund
< $100,000 <1 year $1,000-$2,000
$100,000-$250,000 1-2 years $2,000-$5,000
$250,000-$500,000 3-4 years $5,000-$10,000
> $500,000 >4 years $10,000-$20,000
These are minimum suggestions, but you should consider having more in the emergency fund if you need to have peace of mind and be able to sleep at night.
Step 1: Get the full employer match in your company’s 401(k)/403(b).
Have you ever heard the expression, “never turn down free money? This typically refers to the match on your employer’s retirement plan. Many employers will put in matching contributions into your 401(k)/403(b) up to a certain percentage of your salary. This is a 100% return on your investment on day 1!! There is absolutely nothing that can beat that!
For example, let’s say you make $100,000 per year and your employer will match you up to 5%. So, if you put $5,000 into your employer’s retirement plan, they’ll put in an equal amount. That’s basically like getting a 5% raise!
Always take free money! This is an incredibly powerful method of investing and saving money.
Step 2: Pay off high interest debt (e.g. credit cards).
High interest debt includes credit cards, payday loans, and high interest student loans. Depending on your philosophy about debt, it’s perfectly acceptable to pay off all non-mortgage debt at this step before investing in other retirement accounts. When I was in residency, my wife and I invested at the same time that we were paying off debt. But, we knew we had the discipline to continue the debt-elimination plan and not waver on it.
It makes more mathematical sense to do that than to avoid all investing while paying off debt. However, from a behavioral standpoint, there is great value in the emotional wins accompanying debt elimination. You’re not wrong to focus entirely on debt elimination before proceeding through the rest of the waterfall steps. It comes down to what you’re comfortable with.
Step 3: Health savings account (HSA).
The health savings account is next because it’s the only account that has a triple tax benefit. Money invested gets deducted from this year’s taxes. It then grows tax-free, and if you spend it only on health care expenses, it comes out tax-free. This is a win-win-win!!
Health care expenditures are 25% or more of your expenses in retirement, so you’ll definitely use it. So, why not take advantage of the extra tax savings now?
Step 4: Max. out the company’s 401(k)/403(b).
If you’ve got money left over to invest after hitting the first 3 steps, go back to your company’s retirement plan and put in the maximum amount possible. For 2020, you can put in up to $19,500. If you only have enough left to invest $15,000, for example, then this may be your last step in the waterfall that you’ll utilize. That’s totally fine! You can celebrate having made really smart choices and taking maximum advantage of tax-efficient options for your portfolio.
If you have the opportunity to use a Roth 401(k) or Roth 403(b), you should strongly consider using it. I love Roth accounts. The money grows tax-free because you don’t take the deduction in the year you invest it. So, when you withdraw it eventually, it comes out tax-free.
That’s important because 75-90% of the money in the account after about 30 years will be money that grew inside the account. Only 10-25% will be from what you invested. That means that all that money that compounded and grew will never get taxed!! Definitely worth it!
Step 5: Backdoor Roth IRA (a tricky but handy part of your investing strategy).
The backdoor Roth IRA is a great option to consider if you still have money to invest at this point. This assumes that you make a higher annual income than the Roth exclusion limits. In that case, you can contribute to a traditional IRA, then convert it to a Roth IRA. This is a simple move, but there are a few catches that make it easy to really mess you up. So, don’t do this move unless you really know what you’re doing and can avoid things like the “pro rata” rule.
Step 6: Invest in a taxable brokerage account.
At this point, you’ve hit all the tax-efficient options there are. So, feel free to invest in mutual funds in a taxable account! If you invest the money for at least a year, it’ll get taxed at long-term capital gains rate (15% in 2020) instead of your income tax rate. That’s still a net tax savings, so it’s a reasonable option to consider.
Step 7: Real estate, non-qualified deferred compensation plans, and other taxable investment vehicles.
If you’re interested in real estate investment or have options to contribute to deferred compensation plans through your company, this is a great opportunity to do so. If these vehicles aren’t available to you or sound too complicated, you don’t necessarily have to use them. You could read about them, learn about them, and/or get a good financial advisor, but it’s not a required part of the tax-efficient waterfall investing strategy.
Step 8: Pay off low interest debt and your house.
As I mentioned earlier, it’s perfectly reasonable to consider moving this up to step 2. Not everyone will feel comfortable saving debt to the end of the waterfall, and frankly that makes a lot of sense. Nothing builds wealth faster than being completely debt-free.
All debt equals risk. 100% of foreclosures occur on homes with a mortgage. Feel free to aggressively pay off your house and get that mortgage payment out of your life! If you choose to save it for step 8, my advice is still to lean into it and pay it off aggressively.
One of the main things that separate people who succeed or fail with their finances is having a long-term plan. The tax-efficient waterfall investing strategy isn’t the only option to use, but it’s highly effective.
I also like that it’s elegant in its simplicity. You don’t have to be a financial wizard to excel at personal finances. Follow these steps, know your long-term goals, and stick to your plan. If you do that, you’ll definitely win with your finances.
- Listen to the companion podcast episode with Sarah-Catherine Gutierrez
- What to do if you want to retire with enough money
- You can be a millionaire, and you should!
- The beginner’s guide to student loan management.
- Financial goals: begin with the end in mind.
Please leave a comment below! What are your investing tips?
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