Monday, September 19, 2016
Always Be Frontloading?
As you've surely found out by now, we've stolen all the ideas we use for financial independence. The concept itself we got from Mr. Money Mustache. We learned how to invest in index funds from Jim Collins. We learned that living with our parents well into our forties was okay from Joe and O.G at Stacking Benjamins. So, I borrow from the real experts. But what do you expect? I majored in English, not Finance.
One of the concepts we put into place over the past year is frontloading, which we liberally borrowed from the Mad Fientist. Frontloading is investing more funds in the early part of the year, instead of evenly throughout a time period. Even if you're investing the same amount of money as you would if you dollar cost averaged, by getting more of your money into investments earlier, it has more time to compound and grow.
This frontloading is being done primarily in our 401k. (Mrs. Done by Forty is still in school getting her PhD, so no 401k for her, yet.) But next year, we may do the same sort of frontloading with our IRAs.
The primary reason we're frontloading is to defer paying federal income taxes, especially those on my annual bonus. It's a big, one-time payment that hits in late February or early March. And that lump some payment puts us in a bit of a bind.
We can either pay roughly half of the bonus check to the federal government, or find some way to shield it from taxation. The tax deferral tool we have in my paycheck is the 401k. The way I figure it, we are either frontloading our 401k investments for the year, or frontloading our tax payments for the year. And when it's framed that way, it's a no brainer.
As Mad Fientist notes, since the trend of stocks is to go up in value, you are (more often than not) better off putting your money into investments as early as possible. While dollar cost averaging has some advantages, it's generally a sub-optimal strategy: you're better off getting as much of your money in play as early as possible.
And if we didn't like the notion of frontloading, the other option is paying a big chunk (roughly a third) of our federal income tax early. No thanks.
Trying to take this theory a bit further, I'm wondering if it might be prudent (or legal) to underpay our federal income taxes early in the year (i.e. - claiming a higher number on my W4), and then scaling up our federal income tax payments later in the year. We can pretty accurately estimate our tax owed. And we'd pay the same amount either way. Can't we just pay as little as possible early in the year, and then catch up in the fall and winter?
Ramping up our tax payments would allow us to incrementally front load even more, while still meeting whatever tax target we have.
Of course, there are some downsides. For one, this might not be entirely legal. The government might not like the idea of someone strategically paying their taxes as late as possible during the year. Any tax law experts or CPAs out there?
Secondly, I have to be careful frontloading my 401k, due to the way my company matches. I have to contribute at least six percent every pay period in order to get the full match. Front load too much, and I'll be missing out on a 100% match on my money in a misguided attempt to defer a few taxes and invest earlier.
Third, like just about every reader of this blog, I assume, we are investing a really big amount of money each month no matter which account we invest in. Does it really matter if I'm putting an extra $1000 into my 401k rather than a similar amount into a taxable Vanguard account? That is, minus the taxes I have to pay on any money I invest with my post-tax dollars, am I just shuffling money around by frontloading?
Alas, my lack of true finance skills puts me at a loss, and I have to rely on you kind readers again for advice. What do you think about frontloading? And am I tempting fate (or prison) if I try to pay taxes as late in the year as possible?