In 1985, I crept out from the shadows of the cash economy to join the formal labor market. I took tickets at the Arcadian Cinema, working 20 hours a week at $3.35 an hour. After two weeks, the theater manager handed me my first paycheck.
I’d done the math: 40 hours at $3.35 an hour was $134—serious money when a Big Mac cost $1.60. I opened the envelope, twitched. “I earned $134,” I told my manager. He took the check, pointed to the paystub. “Taxes,” he said. I stared at a mosaic of rectangles, each itemizing a charge that turned $3.35 an hour into something less than $3.00. What the heck was OASDI?*
When I mowed lawns, raked leaves, and delivered newspapers in the underground economy, $1 was $1. In the formal economy, $1 was less.
My first paystub imparted a lesson: I needed to limit the income subject to these rectangles. Passive and active strategies can help.
Passive strategies: employer-subsidized health insurance and workplace retirement plans
Passive strategies demand no effort. In 2023, my employer paid $22,000 to subsidize health insurance for my family of four, an “income” substitute that never showed up in my paycheck.
Assume that my wife and I earn $150,000 per year. Our marginal tax rate (the rate paid on our 150,000th dollar) is 22%. If our $22,000 subsidy counted as income, we’d owe more than $4,000 in taxes. But employer-paid health-insurance escapes taxation.
And in 2023, my employer enrolled all workers in our company’s retirement-savings plan. (We can opt out. Almost no one does.) Our contributions are exempt from immediate taxation. Each $1 invested in the plan reduces our taxable income by $0.22. For higher earners, the benefit is bigger. (Note: We’ll pay tax when we withdraw these funds. In the meantime, our savings grow tax-free, and we can strategize to minimize future taxes.)
Active strategies: Roth IRAs and HSAs
Active strategies demand effort. Tools include the Roth Individual Retirement Account (IRA) and the Health Savings Account (HSA).
Unlike a traditional IRA or 401k plan, the Roth IRA provides no tax deduction on contributions, no shelter from the paystub’s rectangles. But these contributions and their earnings can escape future taxation. Venture capitalist Peter Thiel has tiptoed through the tax code to accumulate more than $5 billion in his Roth IRA. He may never pay a penny of tax on this fortune.
If you earn too much ($161,000 for singles, $240,000 for married couples filing jointly in 2024), you can’t contribute directly to a Roth IRA. But anyone with earned income can sneak money into a Roth through the “backdoor.”
The transaction has four steps:
- Make a nondeductible contribution to a traditional IRA. There are no income limits for nondeductible contributions.
- Place the nondeductible contribution in a money market fund. (This step is typically automatic. At most brokerages, you need to put new money into a “settlement account,” a money market fund or bank account.)
- Convert the traditional IRA to a Roth. Most brokerages make it easy to execute this conversion. You’ll owe taxes on whatever your nondeductible IRA contribution earns before the conversion. But if your traditional IRA has been sitting in a settlement account, your tax bill will approach zero.
- Invest the Roth funds in stocks and bonds. After the conversion, your money will move to a new settlement account—money market fund, bank account—inside the Roth IRA. Move these funds into a mix of stocks and bonds consistent with your goals.
This figure compares the growth of a $1 contribution to a “backdoor Roth” with its alternatives: a nondeductible contribution to a traditional IRA and investment in a taxable account. I assume that the investment grows at 6% per year for 25 years. I also assume that the owner is subject to an income tax rate of 22% and a capital gains tax rate of 20%.
Source: Author’s calculations
Before taxes, $1 grows to $4.29 in each account. When the money is withdrawn, the nondeductible IRA investor owes income taxes, which trim $4.29 to $3.35. The taxable account investor owes capital-gains tax. This tax trims $4.29 to $3.43. (If this investment had generated dividend or interest income during the 25-year holding period, its final value would be less than $4.29.) The Roth IRA investor pays no tax: $4.29 is $4.29.
An HSA is like a Roth on steroids. The catch: To contribute to an HSA, you must be enrolled in a high deductible health plan (HDHP). As the name implies, an HDHP means you’ll pay high deductibles, or out of pocket costs, before your insurer kicks in a dime.
In 2023, my family paid $7,000 in cold, hard cash on prescriptions and doctor’s visits before our insurer would cover all expenses. In exchange, we were able to contribute to an HSA, hitting the tax-break trifecta:
- Contribution to the HSA were tax-exempt, shielding our earnings from the paystub rectangles.
- The investments in our HSA grow tax-free.
- HSA funds used to pay for a qualified medical expense can be withdrawn tax-free.
And this last provision is flexible. As long as we have medical receipts equal to our withdrawals, we can use the HSA for anything—a new car, a weekend in Vegas, or medical expenses such as Medicare premiums and long-term care.
The figure below compares $1 invested in a Roth with the equivalent investment in an HSA. The key difference: The Roth dollar is invested after taxes have been paid; the HSA is invested before. At a marginal tax rate of 22%, a $1 Roth contribution is the same as a $1.28 HSA contribution. After 25 years, the pre-tax $1.28 invested in the HSA is worth $5.50. The after-tax $1 invest in the Roth is worth $4.29.
Source: Author’s calculations
Tax breaks after labor
When we leave the workforce, we lose access to most of these tax-minimization strategies. Without earned income, we can’t contribute to a 401k plan or Roth IRA. And without tax-free employer subsidies, we dig deep into our savings to pay for health care with after-tax dollars.
We confront a new mosaic of rectangles. Let the games begin.
–A. Clarke
*The Old-Age, Survivors, and Disability Insurance (OASDI) program, better known as Social Security.