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Tax-Efficient Planning & Tax-Free Investment Strategies
Ask most people what their largest lifetime expense will be and they'll say their house. For most of the clients we work with, it isn't. It's taxes. High income earners can pay close to 50% of what they make once you add up federal, state, payroll, and capital gains taxes. Over a 40 year career, that is a number most people never stop to calculate.
Here is the good news. Taxes are one of the few areas of your financial life where planning ahead produces a measurable result. You can't control the market. You can control a meaningful piece of your tax bill.
Tax-Efficient
Planning
1. The Three Buckets
Every dollar you save lives in one of three tax buckets.
Taxable — brokerage and savings accounts. You pay tax on interest, dividends, and gains along the way.
Tax-deferred — traditional 401(k)s and IRAs. You get a deduction today and pay ordinary income tax when the money comes out.
Tax-free — Roth IRAs, Roth 401(k)s, municipal bonds, and properly structured cash value life insurance. You fund these with after-tax dollars, and qualified withdrawals come out with no tax at all.
Most people we sit down with have nearly everything in the middle bucket. That feels great in your 40s when you’re taking the deduction. It feels a lot worse at 73 when required minimum distributions push you into a higher bracket than you were in while you were working.
2. Strategies and Investments to Consider
Roth conversions: The years between retirement and Social Security are often the lowest income years of your adult life. Moving traditional dollars into the tax-free bucket during that window can be done at a real discount.
Asset location: Holding high interest strategies like bonds, covered call strategies, structured products, and high dividend stocks/ etfs in an IRA is more tax efficient that a non-qualified brokerage account while keeping assets with high appreciation and low yield in a taxable account is a great way to maintain proper asset allocation while keeping tax efficiency front and center..
Unique Investment Planning: Oftentimes there are traditional tax rules that apply to most people in most situations, but sometimes there are tax benefits associated with special parts of legislation that allows for massive tax savings if used properly. One example of this is Qualified Opportunity Zones. This is a real estate based investment that can allow for tax deferral of realized gains and also, if held for 10 years, can give you tax exempt gains on the underlying investment. Active tax loss harvesting, securities backed line of credit, properly structured oil & gas investments, these are all unique opportunities to gain massive benefits and can often be combined to produce huge tax savings for yourself as well as benefiting future beneficiaries
FAQ
Should I be putting money in a Roth or a traditional 401(k)?
It depends, and I know that’s the answer nobody wants. The real question is whether your tax rate is higher today or higher when you take the money out. If you’re early in your career and expect to earn more later, Roth dollars are usually the better trade. If you’re in your peak earning years in a high bracket, the deduction today may win. Most people we work with end up doing some of both, because having money in more than one tax bucket gives you options later. Flexibility in retirement is worth a lot more than people realize.
Isn' t it always better to take the tax deduction now?
Not always, and this is one of the more expensive assumptions out there. A deduction today is worth your current marginal rate. The tax you pay later is at whatever rate applies then, on a much bigger balance. If everything you own is sitting in a traditional 401(k), at 73 you’ll be taking required minimum distributions whether you need the money or not, and those distributions can push you into a higher bracket than you were in while you were working. Taking the deduction is not wrong. Taking it on every single dollar for 40 years often is.
I make too much to contribute to a Roth IRA. What are my options?
More than you’d think. Roth 401(k) contributions have no income limit at all, and a lot of plans now allow after-tax contributions that can be converted. There is also the strategy commonly called a backdoor Roth. Each of these has rules and moving parts that need to be handled correctly, and a mistake can create a tax bill instead of avoiding one. This is an area where I’d strongly encourage you to work with an advisor and your CPA together rather than reading a post online and doing it yourself.
When does a Roth conversion actually make sense?
The window we look at most often is the years between when someone retires and when Social Security and required distributions start. For a lot of clients those are the lowest income years of their adult life, which means you can move money into the tax-free bucket at a bracket you’ll never see again. A conversion is not free, you’re paying tax today to avoid a larger one later, so it has to be run through the numbers first. Done in the right year at the right amount, it can be one of the highest value moves in a plan.
Can my CPA handle all of this?
Your CPA is essential and we work closely with them, but tax preparation and tax planning are two different jobs. Preparation is looking backward and reporting accurately what already happened. Planning is looking forward and changing what’s going to happen. By the time you’re filing, most of the opportunities for that year are closed. The strategies that move the needle, conversions, asset location, timing a business sale, deciding which account to pull from, have to be decided in advance, and that’s the conversation we’re having.