We presented a tax planning program today sponsored by the Washoe County Medical Society as a member benefit.
Plan your lifetime tax bill to keep more of what you earn.
Good tax planning is not about finding a loophole. It's not an aggressive or risky set of tax strategies.
Good tax planning is simply knowing the financial rules that affect you and fairly abiding by them.
What does your personal "tax profile" look like?
Everyone has a unique tax profile. It is determined by your income, as well as the assets you own and debts you incur. Your status as an employee or business owner also has a major impact on your tax profile.
Some profiles are less efficient than others. We enjoy investigating tax profiles and scouring them for opportunities. We suggest that you start by reviewing your current and historical tax returns, then considering them with the information below.
When you think about taxes, are you looking backward or forward?
Many high-earning professionals consider taxes in the context of preparing their yearly tax return. This is called Tax Preparation.
Tax preparation is an important activity. It's the act of reporting our tax-related activity in the most recently finished year. Most tax preparation also focuses on mitigating your tax bill in that single year. That is a worthwhile endeavor. However, since tax preparation tends to occur after December 31, and look backward, your tax profile is largely set in stone. Too much of a focus on after the fact reporting might cause you to win that year's tax battle, while losing the larger war over your lifetime.
Tax Planning, in contrast, tends to be more forward-looking than tax preparation.
Good tax planning looks for opportunities before it is too late. Good tax planning represents proactive action, organized to make the most of the current tax year and all the years of your life to follow.
Instead of reporting the final version of your tax return, with a few tweaks and deductions around the edges, a good tax plan seeks to win larger war in mitigating the taxes over your lifetime.
How to apply tax planning to you
You can apply tax planning concepts to your own personal finances by focusing on two main areas, Income and Environment:
Our definition of "Income" is straightforward. It represents your earnings and payments from pension plans and Social Security. How much did you bring in this year? A lot? The usual? Less than usual?
Our definition of "Environment" is also straightforward, but it encompasses multiple situations that affect you and your potential tax profile. More on that below.
With most levels of income and in most environments, tax opportunities are present.
Opportunity exists whether your income is relatively high, normal, or relatively low. "Relative" is the key word. Where is your income this year relative to what is normal for you?
There are two general types on income. Most of us are experienced with the first type, called Ordinary Income. This type of income is earned as an employee or owner of a business.
We may be less familiar with the second type, which we call "Gain Income". You may know this type of income by its formal name: Capital Gains. This type of income is realized after the growth (and usually) the sale of an asset.
Both income types are subject to tax.
To illustrate how your income will be taxed think of any income generated as water added to a bucket.
As more water is added (as you earn more money), you reach higher levels of taxation on your income. In the illustration below, enough income was generated to fill the bucket to the top of the 15% tax bracket. Therefore, this income is all taxed at 15%.
Notice how the tax rate rises to 30% if the water gets any higher. Over that black line, any additional income will be taxed in the higher 30% bracket.
Opportunity in a lower income year
What if you earned less in one year than usual?
Your income tax bucket may look like this:
Note the white space below the top of the 15% bracket. This represents the remaining amount of the (theoretical) 15% tax bracket.
This gap is a great opportunity!
Tax brackets exist as a 'use it or lose it' opportunity. That is, if you don't fill up the tax bracket with income in the current year, that bracket is lost forever!
Other than working more to create more income, how can you "use" the rest of the bracket in a lower income year? Fortunately, there are far better ways than assuming that you're able (or willing) to work more.
For example, a great tool to create income is a Roth conversion.
A Roth conversion increases your income, just as if you had earned it by working more shifts, but it does so easily at the push of a button. A Roth conversion is a transfer between any pre-tax IRA or 401(k) to a post-tax Roth IRA or Roth 401(k).
After a well-executed Roth conversion your tax bucket may look like this:
* If you're age 65 or older and you choose to purse a Roth conversion, be careful of incurring a Medicare IRMAA ‘penalty’. There is always a two-year lag: 2020 actions affect 2022. 2021 actions affect 2023.
Note how you've captured the entire available tax bracket, without moving into the higher 30% tax bracket.
You've captured an opportunity to pay income taxes at today's known (and hopefully favorable) rates.
Why would you ever choose to pay a tax bill today if it is not due?
Keep in mind that there are income taxes embedded within your retirement accounts (IRAs and 401(k)s). These taxes exist as a silent liability. You (or your beneficiaries) will someday pay most or all of this tax bill*. Even your death does not eliminate the government's claim on your savings.
With the action of a Roth conversion you're choosing to strategically pay this inevitable tax bill at a known and favorable rate.
Paying taxes today has several additional benefits:
- Less estate taxes: If estate taxes are a concern, a Roth conversion can decrease your taxable estate. Further, it can be viewed as paying these taxes for your eventual beneficiary. Roth assets are received income tax-free to beneficiaries.
- More tax diversification: Your personal tax profile benefits from balance between pre-tax assets and tax-free assets. Read more below under "Asset Location". The right balance of assets of different tax effects can protect you against unknowable future tax rates.
- Less required distributions: A retirement account usually forces you to distribute a minimum amount each year once you reach age 72 (previously age 70.5). While a Roth account also has forced distribution provisions, these distributions are not taxed. This has additional benefits: You might fall to a lower tax bracket than had you not done the Roth conversion, less of your Social Security benefit may be subject to tax, and your Medicare premiums may be lower.
- Less taxable income: Less income (usually not good) is different than less taxable income (good). A Roth conversion causes less future taxable income. This allows you to maintain the same amount of income but just less of it is subject to tax. Even if tax rates remain unchanged, paying the bill today can keep you from drifting into a higher future tax bracket tomorrow.
* Unless your beneficiary is a qualified charity.
Opportunity in a higher income year
What if you earned more in one year than usual?
Rather than seeking to fill up a "gap" in your income tax bucket, you might want to shed water and drop down to be taxed at a lower tax rate.
If you're having a relatively higher income year, one of the best tools you can use is the charitable gift deduction.
You can deduct from your income, dollar for dollar, any amount that you give to a qualified charity.
Since the most expensive way to give is with your checkbook, we very much encourage the use of a Donor Advised Fund to achieve your charitable intentions.
We will expand upon the many benefits of a Donor Advised Fund in a future article.
For now, consider that with a Donor Advised Fund you can:
- Take an immediate tax deduction, while maintaining the ability to gift the same dollars to charity over your lifetime
- Potentially give more through growth
- Simplify record keeping
- Donate long-term appreciated securities, or complex assets, rather than cash
Opportunity in capturing all one-time and reoccurring deductions
Maximize your available retirement account contributions
As for which accounts to contribute to, read more below on Asset Location.
If possible, contribute to a Health Savings Account (HSA)
For an HSA to be available to you, you must first have a qualifying 'high-deductible health plan'. If you do, HSAs are one of the best deductions available.
No other account provides a triple tax break - a deduction up front, tax-deferred growth, and tax-free withdrawals for qualified health expenses. With estimates of the lifetime cost of health care in the hundreds of thousands of dollars per person, this is an important account to maintain.
For those that are healthy, or fortunate enough that health expenses can easily be paid out of pocket, HSAs have other options.
- HSAs can be considered a secondary emergency fund. If you pay qualified expenses out of pocket, and document your payments, you can reimburse yourself from your HSA at any time for expenses paid in this and in all past years.
- HSAs can be considered a secondary pre-tax IRA. At age 65, your HSA can be rolled into your existing IRA. This exists as a one-time lifetime option. There are few situations where this action makes sense.
Before your HSA balance grows too much, read up on the beneficiary provisions of HSAs. They are more restrictive and potentially troublesome than all other tax-favored accounts. Ideally, your spouse could be your beneficiary.
Capture unique opportunities if you're self-employeed (1099 income)
- Consider setting up and funding a solo or group 401(k) Plan
- Capture a health insurance deduction
- If applicable, capture a Qualified Business Income deduction (QBI, Sec 199a)
- Capture a payroll tax deduction
The state of the world, both good and bad, also presents opportunities to improve your tax profile.
Tax environment opportunities
One example is the ever-changing state of tax rates.
Past tax rates can provide context on where we are today and where we may be likely to go next.
We believe that this image shows that top tax rates are relatively low, especially on high earners, at least when considered historically.
If so, and you expect future rates to be higher, it may make sense to pay more in taxes today. This may be true even if you are in today's top tax bracket. What will tomorrow's top tax bracket be?
Where do you think tax rates be 5 years from now? How about in 50 years?
We encourage making the most of the available tax brackets each year.
World environment opportunities
Another example of the opportunities present in certain environments exists within the current state of the world as represented by an individual country's stock market.
For example, the stock market in the United States tends to grow over time. The blue sections below represent relatively long, strong periods of growth. This growth is punctuated randomly by periods of decline, as shown below in red.
If this pattern continues, the (historically temporary) periods of decline continue to represent opportunities to harvest tax losses that can offset future potential gains, as well as to rebalance your portfolio back to target risk levels.
Although current events tend to count more heavily in our minds than earlier events, it is important to try to keep the bigger picture in mind.
Your investment portfolio and your taxes are connected at the hip.
In March 2020, the Coronavirus pandemic caused a sudden decline in asset values. Almost as quickly, these prices snapped back to their previous levels. This chain of events presented a brief opportunity to capture tax benefits. There will be future opportunities for those who are prepared and can remain objective. While we agree with Warren Buffet that making investment decisions from the daily news is one of the worst things you can do, the items we are referring to are pre-planned items that await the right environment as an opportunity to act.
- Remain aware for opportunities to harvest losses or capture gains. With the right investments, you can view declines as an opportunity to fill up your "tax bank account". Be careful, buying and selling can have major tax consequences that may not be apparent immediately.
- Remain aware for opportunities to rebalance your investments, particularly in your taxable accounts. This is a form of discipline and risk control.
Your other portfolio environment opportunities
Yet another example of the opportunities present in certain environments exists behind the scenes, not with the investment strategies you choose to use, but within the tools you use to pursue those strategies.
EXPENSES (COSTS & TAXES)
The portfolios of many high earners unintentionally hold expensive assets. We've proudly championed lower costs for decades by providing transparency around traditional measures of portfolio expenses including expense ratios, bid-ask spreads, commissions, and advisor fees.
There are additional tax-related costs that deserve just as much attention, yet they are still largely ignored.
Investigate the ongoing tax cost of your portfolio. Look beyond the returns you capture to the returns left after tax. Portfolio tax bills are clearly listed on your tax return in schedule D. Don't allow them to remain hidden. Examining the tax cost of your portfolio could result in significant savings.
Many high earners hold profitable assets, but they hold them entirely, or too heavily, in the wrong type of account.
To find the 'right' type of account in the right amount for you, consider how the assets within the account are taxed today, and how they will be taxed in the future.
We separate accounts into three buckets, as shown below. The taxation of each bucket is different.
Assets in bucket 1, including 401(k)s and Traditional IRAs enjoy a tax deduction on contributions but in return will be taxed at a future rate when distributed. Consider that this rate is unknowable today.
Compare bucket 1's tax treatment to assets in bucket 3. You will find them to be opposites. Assets in bucket 3 do not receive a tax deduction on contributions, but they should never be taxed again when distributed (a 0% future rate). These accounts include Roth IRAs and Roth 401(k)s.
Finally, just like in bucket 3, assets in bucket 2 also do not receive a tax deduction on contributions. In addition, just like bucket 1, assets in bucket 2 will be taxed at a future rate when distributed. What is unique to bucket 2 is that these assets can be taxed whenever you choose. They can be held untaxed for years or be taxed over time. Finally, even after they are taxed, they can be distributed or remain in the account.
Depending on your personal income and the environment, certain types of assets should be held in certain types of accounts. It is important to seek a balance between the level of assets held in each of these types of accounts.
When to apply good tax planning
Good tax planning requires consistent attention year-round. Opportunities to influence an outcome expire and can be fleeting. Actions almost always must be taken within the calendar year to be reported for that year.
While each year presents an opportunity to act, good tax planning solutions may require multiple years to fully effect.
Beware knee jerk reactions or “quick fixes” designed around a product sale (such as annuities and whole life insurance).
If it has been awhile since your tax profile has experienced a tax planning review, be warned that there might be significant costs required to reach a better lifetime tax profile. It is possible that a long-term gain may require worsening a tax situation temporarily.
We don’t know what will happen, but we’ll know exactly what to do when it does.