Travis Allen, CFA, CFP®, RICP®

Travis is a Wealth Management Advisor and owner of Custom Wealth Planners. Travis has been working with high-net-worth families for more than 15 years. He specializes in retirement distribution and tax planning. Learn more about Travis here.

Throughout the year we’re regularly collaborating with clients and their CPAs to come up with various strategies to help manage for what many is their largest single line-item expenditure of their lifetime…Taxes. It’s often this time of year that all of those great ideas begin to formalize, and we begin execution to realize the value of that work.

But what does tax-planning mean? How do you know if your current advisor and tax professionals are helping you capture the value of this process?

Let’s get into that and more with this post…

What is Tax-Planning?

Far too many people operate in the dark when it comes to their tax situation. They let their W2s, 1099s, and other tax forms stack up on their kitchen counter until it’s time to drop them off at their CPAs office or enter them into their tax software. A preliminary phone call from the CPA or a watchful eye on the “Refund/Owe” section of their software is typically the first indication of what their tax reality will be for the year. In these circumstances, a refund often means it’s a good year; owing more to Uncle Sam means something is wrong. Unfortunately, neither are indicative of success or failure from a tax standpoint.

Tax-Planning allows us to move beyond this reactive nature of filing your taxes and hoping for the best. We learn ahead of time what you might owe in taxes, and from there can be more purposeful in taking actions to help manage those taxes from year to year. It’s also important to note that the overall goal of tax planning is not to minimize taxes in any given year. Instead, the process aims to lower your effective tax rate across your (and perhaps the next generation’s) lifetime. Somewhat counterintuitively, this may lead us to purposely pay more in taxes today to avoid a ballooning tax bill in the future.

What Does Tax-Planning Look Like?

  1. At minimum, a process that brings clarity to your current-year tax situation:
    • Developing reasonable estimates of income and tax deductions/credits.
    • Based on those estimates, we calculate taxes that will be due and develop a plan of when and how you’ll pay those taxes. (adjusting withholding, estimated tax payments, or payment at tax time)
  2. For many, it’ll make sense to extend these tax projections into future years to gain clarity of both your short and long-term tax picture.
  3. With longer-term clarity, we’re able to make better informed decisions around the steps to take now and in the future to help lower your lifetime effective tax rate.
  4. Repeat annually. Legislation, individual circumstances, and strategies evolve over time.

What are some regular areas that can be addressed with Tax-Planning?

While the tax code is needlessly complex and there are endless areas to be addressed based on unique circumstances, below are a few of the areas we regularly review as part of our year-end process. They represent tools/strategies that provide some level of control around when and at what rate you pay taxes.

Proper Use of Tax-Advantaged Accounts

  • Workplace-Sponsored Accounts: There’s a ton of nuance to all of these, but it’s worthwhile to know if these accounts are offered by your employer and if you’re eligible to participate.
    • 401(k), 403(b), SIMPLE IRAs, Thrift Savings Plans (TSP), etc.
    • Non-Qualified Deferred Compensation Plans
    • Health Savings Accounts (H.S.A.)
    • Flexible Spending Accounts (F.S.A.)
    • Employee Stock Purchase Plan (ESPP)
  • Traditional IRAs: If under income thresholds, these can allow you to contribute up to $6,500 ($7,500 if 50 or older) and deduct against your current year income.
  • Roth IRAs/Backdoor Roth Contributions: While Roth IRAs do nothing to reduce your current year taxes, they are great tools to accumulate wealth on a tax-free basis over time. You can make direct contributions of up to $6,500 ($7,500 if 50 or older) if under certain income thresholds. For those over income limits, visit with your advisor or tax professional about how backdoor-Roth contributions work.
  • 529 Plans: Another tool that will not reduce your upfront Federal tax burden, although many states allow for upfront State deductions. These vehicles do allow for both State and Federal tax-free accumulation and distribution if used for qualified educational expenses.

Reviewing Tax Implications of Your Investment Portfolio

It’s important to recognize that the IRS taxes various forms of investment returns differently depending on the type of return they produce. (i.e. interest, long or short-term capital gains, nonqualified vs. qualified dividends) Certain types of returns can be taxed as low as 0%, while others as high as 40.8%. If any of your investments are held outside of tax-advantaged retirement accounts, be aware of how the items below can impact the after-tax return you achieve.

  • Tax-Loss Harvesting: Regularly review your taxable portfolio balances for any holdings that can be sold at a loss. These losses can offset current or future year capital gains, and up to $3k of excess losses can be used to offset your non-investment income per year. If you do sell an investment at a loss, you’ll need to be sure not to repurchase that same security within 30 days to avoid wash-sale rules.
  • Capital Gain Harvesting: If you find yourself at or below the 12% tax bracket, you may be eligible to sell assets and avoid paying Federal taxes on any long-term capital gains derived from that sale. This can be a great strategy for generating Federally tax-free income for those at lower income levels.
  • Capital Gain Distributions: Mutual funds must make a special distribution of any gains that they recognize throughout the year. This amounts to them giving you a portion of your own money back and forcing you to pay taxes on that amount. Make sure you or your advisor are aware of these and whether you’d be better off sidestepping an unnecessary return of your capital and tax consequences.
  • Asset Location: A diversified portfolio should own a broad range of investments regardless of their tax (in)efficiency. One way to help reduce the tax bite is to own the more tax-inefficient holdings in a tax-sheltered account. (i.e. IRA, 401k, Roth) Investments in taxable bonds, publicly-traded real estate, international stocks, and commodity exposure should be owned in these tax-sheltered accounts to the degree necessary/possible.
  • Tax-Cost Ratio Review: Morningstar puts out this handy metric to help bring some clarity on the impact of taxes on your investment returns. Any holdings you have in a taxable account should include a review of their corresponding Tax Cost Ratio. Anything north of 1% per year should get added scrutiny.
  • Tax-Efficient Rebalancing: Rebalancing is an important aspect of any long-term investment strategy. One way to minimize the tax drag on an investment portfolio is to handle the bulk of any rebalancing needs in your tax-sheltered portfolios. (i.e. IRAs, 401k, etc.)

Charitable Giving

  • Giving with Appreciated Securities instead of Cash: Instead of satisfying any charitable gifts with cash, consider using appreciated securities that you may hold in a taxable investment portfolio. If the assets have been held for a year or more, you can deduct the market value of the gift and avoid paying taxes on any of the embedded capital gain.
  • Lumping multiple years of giving into a single tax year: Most individuals end up taking the standard deduction on their tax returns. Those that do receive no Federal deductibility for the charitable giving they are doing. One way to potentially bring back that deductibility of those gifts is to consider front-loading multiple years of giving into a single tax year. This can be done through outright bigger gifts directly to charity, or through gifts made to a specialized account known as a Donor Advised Fund.  
  • Qualified Charitable Distributions (QCD): Starting at age 70.5, you can begin to use distributions from your Traditional IRA to send directly to charity and avoid income taxes on that distribution. Up to $100k per year per taxpayer. Any distributions made with this strategy also counts towards satisfying any RMD requirements as well.
  • Strategic gifting of pre-tax assets (i.e. IRAs) to charities at death: If you have desires to make gifts at death to your favorite charities, consider naming them as beneficiaries of your retirement accounts. They can receive the full market value of those accounts and pay no taxes on that amount.

Retirement Income Strategy

  • Which Accounts to Pull Next Year’s Income: Many in retirement hold investment balances across many different types of accounts. (IRAs, Roths, 401k, Taxable accounts) There can be significant tax savings by having a coordinated approach to handling distributions across these different account types. This can help minimize the overall tax burden of generating your retirement paycheck.
  • Partial Roth Conversions: Pre-tax retirement accounts are a great tool for retirement accumulation. For most, you’re able to save dollars into these accounts and receive a deduction at higher marginal rates during your working years. Once retired, lower income levels open up the opportunity convert a portion of these dollars to Roth accounts at much lower tax rates. Once in the Roth account, assets grow tax-free and RMD-free for your lifetime. Incorporating this strategy can be a gamechanger in terms of lowering overall taxes paid, and substantially increase tax-free income potential for retirees. It also helps lower your overall RMDs of pre-tax accounts noted below.
  • Required Minimum Distributions: Starting at age 73 for some (75 for others), you must start making mandatory distributions out of any pre-tax retirement accounts. Miss those distributions and you’ll be faced with tax penalties up to 25% of the missed distribution amount. Know what your RMD picture looks like and be armed with strategies that can help you better manage them over time. (i.e. Roth Conversions and QCDs)
  • Medicare IRMAAOverall income can impact the amount you pay for Part B and D Medicare premiums. If you’ve recently retired and are on Medicare, you may need to file an appeal to get your Medicare premiums reduced. You should also be mindful of your income levels throughout retirement to avoid unknowingly adding to your premium costs.
  • When to turn on Social Security, Pension, and Other Guaranteed Income Streams: There are many factors that drive the decision to turn on different retirement income streams. While taxes may not be the most important, it should be a factor you consider when making the decision to start these benefits.

Estate Planning

  • Annual Gifting Limits: Did you know you can give up to $17k per year ($34k per couple) to as many people as you want without having to file any gift tax returns? Particularly for those facing potential estate tax problems down the road, this is a great way to help reduce that tax burden.
  • Lifetime Exemptions: In addition to the annual gifting limits, an individual can gift an additional ~$13mm throughout their life or at death. (double that number for couples) Anything in excess of that amount is effectively taxed at a 40% rate before it gets to your heirs. Unfortunately, that exemption amount is scheduled for sunset at the end of 2025, cutting it in half. This is a perfect time to start engaging on your overall gift strategy and determining if there are any proactive steps to take to avoid the impact of the lifetime exemption getting reduced.

Other Areas

  • Calculating and paying only the Safe-Harbor Level of Tax: This is particularly relevant for those experiencing a large liquidity/tax event. Did you know that you only have to pay the minimum of 90% of the current year tax liability or 100% (110% for those over certain thresholds) of the previous year’s taxes owed to avoid underpayment penalty and interest. By deferring payment of any additional taxes owed, the government if effectively giving you an interest free loan that you can turn around an invest with today’s cash yields earning 5-5.5% risk-free.
  • Workplace Equity Compensation Review: Stock options awards vesting/expiring, restricted stock units vesting, and stock purchase plans transactions should have a proactive plan in place to help reduce their tax implications.
  • Health Care Exchange Premium Tax Credit: We’re running into this more frequently with early retirees that have bought a Health Insurance policy on the healthcare exchange. Make sure you have a plan to manage your income so that it doesn’t impact the premium tax credit you may be eligible for.
  • Qualified Business Income Tax Deduction (QBI): More nuances than I care to get into with this, but something you need to be actively managing if you have real estate or are a business owner. Getting the most out of this can impact everything from how much you pay yourself to what kind of retirement plan you should have.
  • Pass-Through Entity Tax Credit Review: The Tax Cuts and Job Acts of 2017 significantly limited your ability to deduct State taxes paid on your Federal return. Recently many States (including Iowa) have implemented legislation that provides a work-around to this limitation. If you’re a business owner, be sure you’ve visited with your CPA about whether making this election would make sense for you.

Want better clarity on your own tax picture and see how these items may be relevant to you? Book a complimentary introductory call today…Book Here

Welcome to Custom Wealth Planning’s blog where founders Travis & Clay share their thoughts on topics that cover Money, Mindfulness, & History.

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