Lower My Lifetime Tax Liability? Yes, Please!
Consider these strategies that may reduce your overall tax exposure
Congratulations if you are among the millions of Americans (and tax preparers) exhaling after making the April 18 tax deadline. You can close the books for 2022. (And if you filed for extension, you’ll get your chance later this year for that sigh of relief.)
If you are like most people, you probably view taxes as a year-by-year exercise over which you don’t have a lot of control. But if you take a step back and view taxes from a “lifetime lens,” you may discover that you have more opportunity than you realized to implement strategies that can reduce the total taxes you’ll pay over a lifetime. We can help.
To be clear, we are not tax preparers who can help you calculate and file your taxes. Rather, we view our role as tax strategists who, drawing on our expertise in financial planning and investments, identify opportunities throughout the lifecycle to create optimal tax efficiency. We then can work closely with your tax professional to confirm and implement these strategies.
Here is an illustration of the kinds of tax-focused strategies we think about across the different life stages:
If reducing lifetime taxes sounds good to you, click on the links below for more details about the strategies that may fit your situation.
For All Adults (Working and Retired): Tax Mitigation Strategies for Any Age
The Retirement Years: Reducing Tax Exposure for You and Your Heirs
The Working Years: Planning Ahead for Income Diversification and Tax Efficiency in Retirement
Minors with Earned Income: Getting the Ball Rolling with Roth IRAs
For All Adults (Working and Retired): Tax Mitigation Strategies for Any Age
Not all tax mitigation strategies are life-stage-specific. Here are a few that can be employed at any age:
Tax-Efficient Asset Location
Many people do not realize that the types of investments you select for a given account really matter based on the tax treatment of the account. A good example is after-tax accounts (i.e., taxable, non-retirement accounts). From a tax perspective, it is not advisable to include investments that have a high tax exposure and thus reduce your overall investment yield. These include:
Actively managed mutual funds, which can incur capital gains within the fund, even if you yourself don’t sell anything. Instead, we prefer to use electronic traded funds (ETFs) that do not generate taxes while being held.
Real estate investment trusts (REITs), which most people don’t know have a special tax treatment. REIT dividends are taxed as ordinary income (unlike regular stock dividends), which dilutes the value of the dividend.
Taxable bonds, which produce ordinary income as interest. There are plenty of good, tax-free municipal bonds to choose from as an alternative fixed income investment.
All this isn’t to say that these aren’t good investments. However, depending on your situation and objectives, they may be more appropriately held in tax-deferred retirement accounts like IRAs.
Tax-Loss Harvesting
No one enjoys a down market year. But within after-tax (i.e., taxable, non-retirement) investment accounts, negative returns can be leveraged into tax deductions that can be used to offset capital gains and rebalance a portfolio. 2022 was a perfect example of a year where tax loss harvesting came into play as a useful strategy for many investors.
There is an annual “loss limit” of $3,000 that can be deducted from ordinary income tax. However, excess losses harvested can be rolled over indefinitely to future years.
Tax-loss harvesting can be complicated and is not appropriate for every investor. Reviewing client portfolios for this kind of opportunity is part of our professional investment management services.
Family Gifting
If you are fortunate enough to have built a net worth that exceeds your lifetime need, gifting can be a tax-effective way to start implementing the transfer of your legacy to heirs while you are still living. Although this is a strategy most individuals don’t look seriously at until retirement, it is a strategy that is available at any life stage.
The current annual gift exclusion in 2023 is $17,000 per giftor to each giftee. So, for example, together a couple could gift up to $34,000 to each of their adult children (or grandchildren) with no tax implications.
For high-net-worth individuals in particular, gifting can help prepare your estate for a potential, dramatic reduction in the Lifetime Gift Tax Exemption in 2025 (the amount that can be transferred to heirs at death without triggering the hefty 40% gift tax). In 2023, the Lifetime Gift Tax Exemption is set at $12.92 million per individual (nearly $26 million per couple). This is set to reset to $6 million after 2024 unless Congress intervenes.
Plus, gifting has the natural, “feel good” benefit of helping loved ones while you are still living. For example, a common form of gifting by parents and grandparents is contributing to 529 college education plans for the younger generation.
What shouldn’t be gifted? Appreciated non-cash assets like stock and property. If you gift an appreciated asset while you are still living, your original cost basis for the asset travels with the gift—and the gift recipient will receive the tax bill on any gains when that asset is liquidated. Alternatively, at your death, the original cost basis for the same asset receives an automatic “step up” to current value, thus eliminating any taxable gain for heirs. Waiting until after death to transfer these types of appreciable assets can result in a much lower tax bill.
Charitable Giving: Deduction Bunching, Family Foundations, Donor Advised Funds (DAFs), Charitable Trusts
When Congress significantly increased the standard deduction in 2017, it largely eliminated the tax incentive for the average taxpayer to pursue charitable giving. Now, six years later, the 2023 standard deduction for taxes filed in 2024 will increase to $13,850 for single filers (and those married filing separately), $27,700 for joint filers, and $20,800 for heads of households. It remains a high hurdle for individuals and families to surpass these thresholds through charitable giving deductions.
For families so inclined, there remain other options to give charitably while still getting a tax benefit. We can help advise clients on the best charitable vehicle for their situation and objectives. Without going into significant detail in this newsletter, potential options include:
Deduction Bunching: Making larger-than-average charitable contributions in a single year and taking the tax deduction for the higher consolidated amount. This can be a strategic alternative to the scenario where you make smaller donations over multiple years but have to forgo a deduction benefit because the amount in any single year is too low.
Private Family Foundations: A private family foundation is a charitable organization that is funded exclusively by members of a family for the purpose of making charitable grants. The entity receives the same tax-exempt status as a public charity, and donors receive tax deductions for their contributions. A family foundation is most typically created by high-net-worth families that wish to maintain a high degree of control over their charitable legacies and are willing to assume significant costs and responsibilities related to this. Strict rules and regulations apply, and violations can result in taxes and substantial penalties.
Donor Advised Funds (DAFs): An increasingly popular alternative to the private family foundation is the Donor Advised Fund (DAF). Less onerous to set up and manage, the DAF serves a similar function of making charitable contributions while providing the owner-donor an immediate tax deduction for contributions. The timing and amount of charitable donations is at the DAF owner’s discretion. The funds have the potential to grow tax-free in the DAF until donated. A DAF can be created with as little as $10,000 and funded with cash or appreciated securities (a great way to diversify out of investments with high taxable capital gains). Subsequent contributions can be made in increments as small as $500.
Charitable Trusts: A charitable trust is a legal trust established to hold, manage, and distribute funds to both personal beneficiaries (including yourself) and charities, based on your instructions. A trust allows you to issue longstanding instructions for the distribution of assets, as opposed to a will, which generally provides for a one-time distribution of gifts. A Charitable Remainder Trust (CRT) first makes distributions to named beneficiaries (yourself and/or others) before giving the remainder to the designated charity or charities. A Charitable Lead Trust (CRT) does the opposite, first making distributions to the charity (or charities) before distributing the remainder to the named beneficiaries. In either scenario, you receive a tax deduction for the charitable distributions made by the trust.
The Retirement Years: Reducing Tax Exposure for You and Your Heirs
Retirement, with its income transitions, presents a unique opportunity to look analytically at shifting taxes to years when income is lowest (i.e., before social security and required minimum distributions begin). It also is the time to implement estate planning strategies that can reduce your tax exposure in retirement and that of your future heirs.
Roth Conversions
If you are coming into retirement with a sizeable pre-tax IRA, the tax bill on all those tax-deferred funds (and their gains) is about to come due. This can be an unpleasant surprise when required minimum distributions (RMDs) start at age 73,* especially if you don’t need the RMD funds to meet living expenses. But one lever to reduce your overall tax liability is to convert your pre-tax IRA (all or partial) to a Roth IRA in any low-income tax year. This is called a Roth conversion.
When income declines in retirement, taxable income typically drops off and you move to a lower tax bracket. If you retire at, say, age 65 and have sufficient savings to support yourself and delay social security, this may be the ideal time to do a Roth conversion.
A Roth conversion is a taxable event. But in one scenario, you may opt to pay taxes on the conversion at the lowest rate during the “gap years” before social security income and RMDs bump you up again. Once you convert funds to a Roth IRA, any future distributions you take will be completely tax free (including gains), and you will never have to take RMDs—thus extending how long the funds can continue to grow.
But the greatest benefit of doing a Roth IRA conversion may be for the next generation. If you do not need all your IRA savings during your lifetime, converting to a Roth IRA will allow the tax-free transfer of funds to future beneficiaries without the tax burden of the 10-year distribution rule for inherited pre-tax IRAs.
A Roth conversion doesn’t have to be a one-time event. In fact, it often makes more sense to do partial conversions over a series of years to keep the tax rate on the conversion as low as possible (too much, and you can bump yourself up to a higher tax bracket). Using special tax planning software, we can estimate the optimal amount and timing that won’t bump you to a higher tax bracket or inadvertently increase social security taxes and Medicare premiums. We can also work with your tax professional to confirm the recommended strategy.
Qualified Charitable Distributions (QCDs)
For the charitably inclined, who do not need all their RMD funds for income, qualified charitable distributions (QCDs) are a win-win for both you and the causes you care about. Starting at age 70 ½, you can make direct charitable contributions to qualified charities from your IRA—up to $100,000 each year (this limit will be indexed and increase after 2024). These IRA distributions are tax-exempt.
If you do QCDs before age 73* (when RMDs start), you are reducing the amount of IRA savings that will be factored into the eventual annual RMD calculations—thus reducing your future tax liability.
If you do QCDs while taking RMDs, you do not pay taxes on that portion of the RMD that is a charitable donation. This is important, because the value of any QCDs is not included in your taxable income, which may help with other calculations based on taxable income, including Social Security taxes, Medicare premium calculations, and medical expense deductions. With QCDs, you also do not have to worry about your contributions exceeding the standard deduction or, if they do exceed, itemizing deductions.
Gifting & Charitable Giving
Gifting and charitable giving are tax mitigation strategies that can be implemented at any stage of life (as described earlier). But it’s worth noting here that these strategies become even more salient in the retirement years as estate planning tools for transferring wealth in a tax-efficient manner.
*The 2022 SECURE 2.0 Act extended the RMD age from 72 to 73, starting in 2023 (affects birth years 1951 to 1959). Starting in 2033, the RMD age will again increase to age 75 (affects birth years 1960 and older). This is positive for investors who do not need to use their IRA funds and wish to keep them invested as long as possible. This also opens a larger window for investors who wish to use qualified charitable deductions (QCDs) to reduce funds in their IRA before they are required to take RMDs.
The Working Years: Planning Ahead for Income Diversification and Tax Efficiency in Retirement
Unfortunately, the opportunities to trim taxes during the prime earning years are somewhat limited. However, this is where a “lifetime taxes” mindset comes into play—thinking ahead about steps that can be taken today to improve taxes in retirement and beyond.
Roth Strategies
For the reasons we’ve discussed previously, having Roth funds can be a very valuable asset in retirement. If you need to use them, you can do so “tax free.” If you don’t need to access these funds, you won’t have to deal with RMDs; Roth funds can continue to grow throughout your lifetime—and pass tax-free to your heirs.
Here are three “Roth-related” strategies you can implement during your working years:
If your employer offers a Roth 401(k) option (most do), you may want to consider contributing after-tax dollars to this instead of the pre-tax 401(k), especially during lower earning years when your tax bracket may be lowest.
If you are eligible, make an annual contribution to a Roth IRA (after maxing out annual contributions to your workplace retirement plan). High-income individuals who don’t qualify because of income limits, may be able to use the “back-door” Roth IRA method.
If you are changing employers and have a small pre-tax 401(k), consider converting it to a Roth IRA with a rollover.
Health Savings Account (HSA) Contributions
If you have a high-deductible health insurance plan, you may have the option to contribute to a Health Savings Account (HSA), which can be a good idea. An HSA is a tax-advantaged savings plan that is specifically for qualified medical expenses and is “triple tax free”: 1) contributions are tax deductible; 2) growth of invested savings is tax-deferred; and 3) spending on qualified medical expenses is tax free. The 2023 contribution limit for self-only coverage is $3,850; for a family, the limit is $7,750. Accountholders over age 55 can contribute an additional $1,000.
Unused HSA funds can remain invested indefinitely. If you are financially able to pay for current medial expenses out of pocket, it may make sense to build tax-free HSA funds for medical expenses later in retirement. After age 65, HSA funds can be withdrawn without penalty for non-medical expenses (but will be taxed).
Minors with Earned Income: Getting the Ball Rolling with Roth IRAs
If you haven’t already figured this out, we are big advocates for the tax and estate planning benefits of Roth IRAs. And, in our opinion, the earlier you can get started with building a Roth nest egg for your future retirement, the better.
If a child is a minor but has earned income (e.g., from babysitting, dog walking, or some other form of employment), parents can open a custodial Roth IRA and fund it up to the total amount earned or annual limit ($6,000 in 2023), whichever amount is lower. The adult will be listed as the custodian, but the account will be in the child's name as the owner. The custodian is responsible for documenting the child's income and demonstrating a reasonable wage rate (i.e., not $1,000 per hour to walk Fido). There are also rules as to whether your child needs to file a tax return, so check with your tax professional.
Any opinions in this newsletter are those of Estes Wealth Strategies and John Estes and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change without notice. The information presented herein has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete. It is not a statement of all available data necessary for making a recommendation, nor does it constitute a recommendation.
Raymond James does not provide tax or legal services. Please discuss these matters with the appropriate professional.
Be advised that investments in real estate and in REITs have various risks, including possible lack of liquidity and devaluation based on adverse economic and regulatory changes. Additionally, investments in REIT's will fluctuate with the value of the underlying properties, and the price at redemption may be more or less than the original price paid.
Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount may be subject to its own five-year holding period. Converting a traditional IRA into a Roth IRA has tax implications. Investors should consult a tax advisor before deciding to do a conversion.