In 2016, we published two posts on tax planning that we would like to revisit and recap in light of the various changes to the tax code enacted with TCJA (Tax Cuts and Jobs Act) of 2017 and the SECURE (Setting Every Community Up for Retirement Enhancement) Act of 2019.
As humans, it’s in our DNA to crave action in moments of uncertainty. It’s the fight or flight instinct. Because of this, successful investing will always be counter-intuitive to many and difficult for most. When it comes to long-term investing, the data and research continue to support an approach that rewards patience and discipline, not action or reaction. Fortunately, not all aspects of managing your wealth require you to resist your wiring. When it comes to tax planning, opportunities abound, in all phases of life, to grab the bull by the horns and act.
In this post, we provide actionable items that you can do to help reduce your tax bill in any season of life, as well as actions to take in the three phases of your financial life – working, at retirement, and in retirement.
Any Season of Life
For our clients, regardless of their stage of life, we always recommend a tax-efficient portfolio. We’ve gone into detail here, but the three strategies for setting up your portfolio as tax-efficiently as possible include: 1) Vehicle selection (Mutual Fund vs. ETF), 2) Minimizing turnover and 3) Asset Location (e.g., 401k vs. Taxable Brokerage Account).
Secondly, we recommend you review your portfolio for tax-loss harvesting (TLH) opportunities on a yearly basis. TLH is the process of selling a security at a loss and replacing it with a security of similar characteristics. By capturing, or “harvesting,” a loss you can deduct up to $3,000 against your ordinary income and roll the remaining losses forward to use in the future. Read more on tax-loss harvesting here.
Phase 1 – Working
For those in the workforce, one significant tax planning strategy is to maximize your tax-deferred saving opportunities provided through your company’s 401k plan. For 2020, the maximum amount you can defer is $19,500 ($26,000 if older than 50). Depending on your company, there might be opportunity to defer additional post-tax salary into a Roth 401k. For Intel employees, click here to learn more.
If your cash flow can support it, the next step is to take advantage of a yearly IRA contribution. In 2020, the annual limit is $6,000 ($7,000 if you are older than 50). Many people are surprised to hear they can still make IRA contributions as high earners. Here’s the catch – depending on your income level, your IRA contributions may be deductible or non-deductible. If you’re able to make a deductible contribution, then great – you’ve reduced your income by $6,000! But what if your income is too high and making a contribution won’t reduce your tax bill this year? There may be an opportunity for what’s call a Backdoor Roth IRA.
Backdoor Roth IRA
While the name sounds suspicious, the strategy is legal and quite effective if used correctly.
- There are income limitations that restrict high-income earners from contributing directly to Roth IRAs
- Anyone can make a standard IRA contribution, but income rules limit who gets to deduct the contribution amount from their tax return
- There are no income limitations when converting Traditional IRAs to Roth IRAs
A Backdoor Roth IRA exploits a loophole that allows for high earners to build their after-tax assets by converting Non-Deductible IRA contributions into Roth IRAs. Unfortunately, because we’re dealing with the tax code, this isn’t quite as simple as it sounds. When converting IRA assets to a Roth, you don’t pay any taxes on the portion of funds you’ve already paid taxes on (i.e., non-deductible contributions), but you do pay taxes on IRA assets that haven’t been taxed yet.
For this reason, the ideal candidate for a Backdoor Roth IRA is a high-income earner with no other IRA assets. If you happen to have a sizable Rollover IRA from a previous 401(k), then the Backdoor Roth IRA loses its appeal because you will be paying higher rates on a large portion of the conversion. Remember, the primary objective of any Roth decision is to fund the Roth vehicle at lower marginal rates than the funds will be taxed during RMD distributions. In the example above, we outlined the process by which an investor makes a non-deductible contribution (at the annual contribution amount of $6,000) to her Traditional IRA. Because her Traditional IRA doesn’t have a previous balance, she can move the full contribution of $6,000 to her Roth IRA without paying the higher rates.
Phase 2 – At Retirement
Many employees face an oversized tax liability when it comes time for them to retire, what with accelerated stock options, bonuses paid out, sabbaticals paid in cash, and so forth. For those who are charitably inclined, a great way to reduce your tax bill in large income years is to front-load charitable giving via a Donor Advised Fund (DAF). In short, a DAF is an account that allows for charitable donations of securities and cash. The donor receives in immediate tax deduction in the year of contribution, and the donated assets continue to grow tax free in the account until the donor gifts them to the qualified charities of their choice. The added bonus is you can donate highly appreciated securities (i.e. Intel stock) avoiding capital gains that would be otherwise owed. For more information, check out our article on using a Donor Advised Fund to optimize your charitable giving.
Phase 3 – Retirement
For those entering the retirement “sweet spot”, when the paychecks are gone and Uncle Sam isn’t forcing you take Required Minimum Distributions (RMDs) at age 72, there are opportunities to take action by “forcing” distributions out of your tax-deferred accounts at lower tax-brackets than you’ll otherwise be in once RMDs begin. Many might see the string of $0s in the tax row and be content with not dishing out anything in taxes for a few years. However, by not “forcing” income out, they lose a great opportunity to reduce their lifetime tax liability. How? Because IRA distributions are taxed at ordinary income rates, those who have significant tax-deferred assets will be bumped back into higher tax brackets once RMDs begin. Bottom line, if you can stomach the initial pain of “forcing” yourself to pay taxes, you will benefit in the long run with a reduced aggregate lifetime tax payment.
If you are on board with strategically reducing your tax-deferred assets prior to age 72, but don’t need the withdrawn funds to live off of, then another tax planning strategy to consider is a Roth Conversion. By moving assets to the tax-free Roth buckets at lower marginal rates than they would be otherwise taxed at later, you can effectively lower your lifetime tax bill. There are no limits on how much you can convert, although it generally makes more financial sense to execute partial conversions. The below chart illustrates this point by highlighting when it makes sense to convert assets and when it doesn’t:
For example, let’s look at a retiree who has significant tax-deferred assets and will most likely be in or above the 22% bracket through retirement. Because of this, he will want to optimize for the 12% bracket. During year-end planning, he makes projections for his base income (Social Security, wages, pension, etc.) and deductions, and decides to convert $46,250 from his Rollover IRA to his Roth IRA to force additional income for the calendar year. By effectively taking action and intentionally targeting the 12% tax bracket, he has reduced his tax-deferred bucket and, more importantly, reduced his lifetime tax bill.
At Cordant, we love tax planning because there are always opportunities, regardless of the phase of life a client might be in. Further, the rules are always changing so it requires us to stay on our game. And while we live be the cliché of all clichés, “Don’t let the tax tail wag the dog”, we believe the tax optimization strategies reviewed above enable our clients to reduce their tax liability while still allowing them to focus on what matters: aligning their resources with their objectives.
If you have any questions on the strategies reviewed or are in interested in working with Cordant, please get in touch.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.