Beyond Tax-Efficient Investing

By JoAnn Huber

September 25, 2020


Beyond Tax-Efficient Investing

When it comes to investing, an essential measure of success is how much of your return ends up in your pocket instead of in Uncle Sam’s. Many people focus on the return without factoring in the drag taxes have on the actual amount of money left to use. Stated another way, they focus on trying to beat the market without considering what’s available after paying taxes. To be truly tax-efficient when investing, you must do proactive tax planning.

Beyond Tax-Efficient Investing
on America’s Wealth Management Show

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Beyond Tax-Efficient Investing

Links Mentioned on this Episode

Podcast: IRAs vs. Roth IRAs Pt. 1  Podcast: IRAs vs. Roth IRAs Pt. 2

Complimentary Consultation

Dean Barber: Thanks so much for joining us on America’s Wealth Management Show. I’m your host, Dean Barber, along with Bud Kasper, and JoAnn Huber, CPA, CERTIFIED FINANCIAL PLANNER™. She’s going to be joining us for the entire show today, and JoAnn, welcome to the show here. It’s been a while, JoAnn. You’ve been on the never-ending tax season this year.

JoAnn Huber: Yeah, it just will not end. Just another couple of weeks.

Dean Barber: A couple more weeks, and you’ll be able to say, okay, all the extensions we can do, are done.

Bud Kasper: Yeah, see you in January.

JoAnn Huber: And then we get to do the part that really matters because we get to focus solely on tax planning, which is where the true value comes.

Why “Beyond” Tax-Efficient Investing?

Dean Barber: You recently wrote a great article called Beyond Tax-Efficient Investing. Several months ago, we had the idea to write this article, because when people think about tax-efficient and listen to the financial media, they will tell you to have a tax-efficient investment strategy. They tout a mutual fund as a tax-managed fund, or they talk about tax-loss harvesting in a portfolio, but that’s not really where the power is with tax planning. So that’s why you wrote this article, Beyond Tax-Efficient Investing. Let’s start with the concept of tax-efficient investing first. Tell me your thoughts there.

JoAnn Huber: Well, a lot of times, people when you hear it, just as you were saying, the thought is, “What account type do I put the money into? Should I have muni bonds or regular bonds?” That seems to be where people focus on tax-efficient investing. However, it’s about a lot more because we want to look at the interplay between your investments and the rest of your taxes? What can we do to control your investment income and how you’re investing to try to minimize your overall taxes?

It Depends…

Dean Barber: All right, so let’s address the question that you just had, which was muni bonds or regular bonds. Which one’s better?

JoAnn Huber: It can depend on the investor.

Bud Kasper: Depends. I know her answer. It depends.

JoAnn Huber: I know. That’s my favorite answer because it does. It always just depends on your individual situation.

Dean Barber: What would make you lean more towards a regular bond versus a muni bond?

JoAnn Huber: Well, we’re going to look at what type of return you will get because obviously we want to keep the most money that we can. If we’re going to keep more if we’re in a regular bond, we’ll lean that way. If we can keep more if it’s in a muni, we’ll lean that way. So you have to look at what it is that the rest of your portfolio is doing. What’s the rest of your tax situation? What type of return can you get from that bond?

Bud Kasper: It’s a filter. It’s always what’s my net result after tax.

Dean Barber: Right, right, right. But today, if you were going to say muni bond or government bond, what are you going to do? Don’t say it depends.

JoAnn Huber: Flip a coin?

Bud Kasper: Dean’s taken it personally.

Looking at the Overall Portfolio Construction

Dean Barber: The point is, you have a 0.6, 7% yield on a 10-year treasury today. Well, I can go out and buy a municipal bond that’s tax-free in the federal, and possibly tax-free as long as it’s issued within the state that you live, but then you can maybe get 3% or 4%. 

JoAnn Huber: But is that really where we want it to be, or are we looking at some other investment that’s going to give us a little better return? You have to look at the overall portfolio construction to say, how much should you have in bond, how much should you have in stocks? And come up with that thing, so it’s not just one individual holding. You have to look at everything holistically.

Dean Barber: Right, and depending upon your tax bracket, you may be able to get dividends from stocks tax-free.

Risk Factors

Bud Kasper: Right, but then you have to enter in the risk factor associated with it. I mean, these are all the right questions to ask, and our audience needs to understand where we’re coming from, but the final result is how much do I get to keep?

Dean Barber: So let’s go. JoAnn, you first in this article start talking about tax buckets. What do you mean by that?

Tax Buckets

JoAnn Huber: Well, there are different types of accounts that are all taxed differently. So we have our taxable accounts, which you’ve already paid tax on, but then you’ll have to pay tax on the earned investment income. The capital gains, the interest, the dividends, and that’s one bucket. Then the second bucket is tax-deferred, and that’s going to be something like your traditional 401(k), your IRA, that you get a deduction when the money goes into that bucket. But when that money comes out, you’re going to have to pay tax on it. The typical third bucket that we talk about is the tax-free bucket, and that’s going to be the Roth. The benefit with that is you get the money out tax-free, and so-

You don’t get a deduction when it goes in, but everything that happens, that growth is going to come out tax-free.

Dean Barber: Okay. Now, you can put as much money as you want to in the taxable bucket, you’re limited to how much can go into the deferred tax bucket, and you’re limited on how much can go into the tax-free bucket. I mean, if we all had our way, we would want every single dollar that we invested in that tax-free bucket, but unfortunately, there’s a lot of rules and limitations that go around that.

It May Not Be for Everyone

JoAnn Huber: Right, and based on your tax situation, you might not be better off, from a tax perspective, having everything in that tax-free bucket. Even though it sounds great, it might’ve cost you a whole lot to get that money in that bucket, and so it’s important to work with somebody to decide where you should be saving. 

Bud Kasper: I think one of the other critical factors, though, Dean, is where are you putting your money every month? Are you going to have that coming out taxable, or is it going to be tax-free?

Traditional vs. Roth

Dean Barber: I don’t think you should be putting your money into anything unless you know what’s going to happen when it comes out. So by the way, we’ve got a great podcast where JoAnn and I go into super detail on Roth versus regular with all the rules, all kinds of age, income amounts, and everything. It’s on The Guided Retirement Show, so find that on your favorite podcast app or YouTube. It’s episodes one and two of The Guided Retirement Show. You’ll get a lot out of it. 

By the way, if you’re saying, “You know what, I’d like to talk to you guys. I’d like to have a conversation.” We can give you a complimentary consultation. We can meet through video, by phone, or in-person. 

Tax-Efficiency for Investing vs. Long-Term Tax Planning

Dean Barber: So, JoAnn, you wrote the article called Beyond Tax-Efficient Investing. This article aimed to help people understand that if you’re going to control your taxes and keep money away from the IRS, it goes far beyond just tax-efficient investing. Tax-efficient investing is part of a well crafted, well thought out, long-term tax strategy, but it’s only a part of it. However, that’s what gets marketed from Wall Street as tax-efficient investing.

You can go out there and Google “tax-efficient investing” and what you’re going to get is a bunch of ads for people’s different investment strategies, and you’re going to think, “Well, that’s all there is.”

Bud Kasper: If I could add one more thing to that, Dean, the article was an easy read. I mean, anybody can understand precisely the points that you were making in the report. I think you’re missing something if you don’t go ahead and read that article.

This Isn’t a “How-To” Strategy

Dean Barber: It’s not a “how-to” strategy.

Bud Kasper: It’s a definition.

Dean Barber: It’s definitions of things that you need to be doing, but how to do it will depend on your own situation, and which one of these strategies you’re going to employ will depend on your personal situation. The only way, JoAnn, that somebody can get a good long-term tax reduction strategy is how?

JoAnn Huber: You have to plan ahead. You have to have a plan and know what it’s doing. As you said previously, you need to know what will happen from a tax standpoint when that money comes out of the accounts. That’s an important part of planning. Right now, as you’re approaching retirement, you need to be figuring out where I need to be saving, so once you hit retirement, you can come up with a distribution strategy that will be tax efficient.

Dean Barber: We’ve said forever here on America’s Wealth Management Show that as long as you live in the United States and as long as you have money or make money, taxes are going to be a fact of your life. The deal here is that what you have to do is create a comprehensive financial plan first, and then your CPA, in our case it’s JoAnn, who’s right here in our office-

JoAnn Huber: And I have a great team also.

CPA + CFP® = Good Tax Planning

Dean Barber: You do have a great team. Then the CPA and their team can sit down and say, “Okay, let’s look at this person’s financial plan, and let’s come up with the best tax strategies for that financial plan.” Because part of financial planning is tax planning, but I promise you that 99.9% of the financial planners that are out there don’t have a CPA sitting next to them, saying, “Let’s really do tax planning here.” They’re saying, “Oh yeah, let’s use this annuity.” Or, “Maybe we can put some money into a Roth IRA.” Or, “Hey, you should use a deductible IRA.” And you think that that’s getting tax advice, and it’s not.

JoAnn Huber: Maybe a little bit, but we want to be comprehensive. We want to make sure we’re looking long term and saying, “This is going to minimize your taxes over your lifetime,” because the more that we can reduce taxes, the more you get to keep.

Bud Kasper: Let me add to that, though. It’s all about the experience, and when you have an opportunity to sit down with one of the CFPs inside the firm, and JoAnn or members of her team, and you actually get to see on a screen the net result of what tax-efficient planning can do for you from a net perspective. What I mean by that, folks, how much money are you going to keep in your pocket that you didn’t keep last year? How about the next year, and the next year? The compounding effect of this type of planning is forever green.

Dean Barber: Yeah, it is, and it’s real money, right?

Bud Kasper: Well, that’s why I said green.

Dean Barber: Green, yeah.

Tax Planning with a Solid Investment Strategy

JoAnn Huber: We want to add tax alpha. We want to make it so there’s value. I mean, how many articles do you read about, “It’s hard to beat the market.” and you do these things with investments, but if we can add that tax alpha, that’s going to make it so your investments, if we have a year where you’re down a little bit, it’s not going to hurt as much on your plan. I mean, obviously nobody likes to lose money, but you’re still going to be okay and be able to do those things you want if you can reduce your taxes.

Bud Kasper: Exactly.

Dean Barber: Well, we’ve seen so many cases, JoAnn, where when we lay out that plan over a lifetime, $200,000, $300,000 of tax savings over a lifetime starting with somebody in their mid to late fifties and taking them through retirement, and if you can reduce their lifetime tax bill by a quarter of a million dollars or more, that’s real money that stays in your pocket. The other thing that it does is it takes the pressure off of the underlying investment.

JoAnn Huber: Even if it’s just a couple of thousand dollars or something, that’s real money we’re talking about that people can use for the things that they want, and it all comes from planning ahead. You have to look at it because if you haven’t done planning before you hit retirement, you’re really not going to have many choices once you get in retirement to control where that money’s coming from and to control your taxes.

Dean Barber: You still can, but it’s just-

JoAnn Huber: It’s a lot harder.

You Have to Look Ahead

Dean Barber: It’s ideal if we can start helping you understand where your money should be put today, say five to 10 years out from retirement, and really start putting that plan together for distribution. So you do have to look ahead.

Bud Kasper: I’ve phrased this to clients many times because what you’re doing right now is tax destruction. You’re ruining your opportunity to get a better return, because you’re destroying it because, lack of a better word, ignorance. You simply aren’t aware of the opportunities that exist out there when you focus on that as part of your comprehensive financial plan.

JoAnn Huber: The nice thing is, is regardless of what stage you’re at, there are things we can do to help you.

Lower Tax Brackets for Tax Efficiency

Dean Barber: You discuss, in this article, taking advantage of lower tax brackets for tax efficiency. What do you mean by that?

JoAnn Huber: Well, taxation on different incomes has different rates, and so one thing we want to look at is if you have qualified dividends or long-term capital gains, it’s possible that those will be taxed at 0%, and it’s hard to beat zero. So we want to look at it and say, are you in a lower tax bracket? Do we want to take advantage of that? Or if we know that you’re in a low tax bracket right now, and say when you turn 72 or later and start the required minimum distributions, you’re going to go to a higher tax bracket. 

We’ll want to pay tax at that 12% tax bracket rather than waiting and paying it at 22 or 24%. So it’s really looking at what your tax bracket is now, what your tax bracket will be in the future, and trying to smooth that out, so we don’t go from 0% to 22% or 24% or higher.

Bud Kasper: Have you seen an article or anything that’s talking about how much more money is going into Roth 401(k)s versus prior years? I’m wondering if people are starting to get it.

Dean Barber: I have not read anything.

Bud Kasper: Me neither.

Understand the Power for Tax-Free Growth

Dean Barber: I’ve not seen any statistics on that, but I think that there are people that get it, that understand the power of the tax-free growth and tax-free distributions of the Roth, but there are so many people that don’t understand the difference, and they look for the immediate benefit of the tax deduction. I think all of the default enrollment plans now are to do traditional, and you have to choose whether you want to do the Roth or not. So I would bet there’s more money still going into traditional IRAs.

Bud Kasper: Simply because people don’t know better. I’ve been railing on this for years. Do you want to get taxed on the seed or taxed on the harvest? It’s up to you.

JoAnn Huber: But I’m still shocked at the number of employers that don’t offer the Roth as an option.

Bud Kasper: It almost seems like they should be forced to.

Dean Barber: But they aren’t. Just think about the fact that there are companies that don’t even have a 401(k).

Bud Kasper: Okay, well, you can make that statement, and then everything will fall into place. “Dean said …”

Listen to The Guided Retirement Show to Learn More

Dean Barber: If you want to know whether you should be doing a traditional or a Roth, I encourage you to get out to The Guided Retirement Show on your favorite podcast app. It’s The Guided Retirement Show, and in season one, episodes one and two, JoAnn and I go into great detail. In those two episodes, there’s about two hours worth of content just on the difference between the traditional and the Roth and at what stage of life you’re in, and what your income amounts are, and whether or not you should be using Roth versus traditional 401(k) or IRAs. Check out The Guided Retirement Show on your favorite podcast app.

JoAnn Huber: I think on the podcast, we do an excellent job of talking about it. For those low and high, it’s easy to tell where you should go. So it’s people in the middle that it’s hard to know, where should I be saving? Should I be doing Roth or traditional? That’s where the financial plan really comes into play, because we can go through and we can model that and look and say, “Okay, here’s your plan if we do the Roth. Here’s the plan if we do the traditional,” that you don’t get. 

I mean, you can run spreadsheets, but it doesn’t give you the same thing as looking at your overall plan. It’s such a value we can add when people come in and meet with us and help them make that decision.

Don’t Put Money in if You Don’t know the Consequences Are When You Take it Out

Dean Barber: I think everybody listening right now needs to take this to heart and say, “All right, I shouldn’t be putting money into anything unless I know what the consequences are going to be whenever I start taking the money out in the future.” 

For whatever goal it is, retirement or a vacation home, or whatever it is, you shouldn’t put money into anything unless you know what the consequences are when it comes out. We can walk through that with you with a complimentary consultation. Complimentary means there’s no cost, there’s no obligation. We can do a video meeting, do a phone call, or do in-person meetings.

2020 Has Been a ROUGH Year for CPAs

Dean Barber: You know, it’s been a rough year this year for CPAs for sure. I mean, you had the SECURE Act at the end of last year, and then you got the CARES Act here in March or April, and still no clarity on a lot of stuff in the CARES Act. There are still questions about the SECURE Act, which was rammed through at the last moment in December of 2019. 

So not only have you had to prepare a ton of tax returns, but you’ve had to try to interpret the laws that were passed by Congress, and yet we still don’t have firm answers from the IRS on how many different things are going to work. So that makes it very, very difficult for CPAs this year. More than any in these 33 years that I’ve been doing this, this is the most challenging time I’ve seen.

JoAnn Huber: And then you throw in all the PPP stuff. We have to be very agile this year.

Dean Barber: Agile CPAs. That’s a good visual,

Bud Kasper: You know, you have to consider the job security that JoAnn has thanks to Congress. Of course, that’s a serious point, because you have to stay on top of what these changes mean to you, and boy, we saw some significant changes this year that people even today aren’t aware of. I just wrote down a note to myself when I said, “Are taxes damaging your retirement success?” Either you’re not aware of it, and you don’t know how to fix it.

So Many People are Missing the Tax Planning Component

Dean Barber: Well, I think you’re right, Bud, and in most cases, people aren’t aware of it. JoAnn, when people come in for their complimentary consultation, and they say, “Okay, let’s go through this process. Help me understand,” I would say more than 95% of the people that we meet with for the first time are overpaying their taxes, and they don’t even know it. It’s not because their CPA prepared their tax return wrong. In many cases, it’s because they missed opportunities that they didn’t even know existed.

JoAnn Huber: I would agree with that. When I look at this year, there are so many opportunities available to people because of the SECURE Act and the CARES Act and different things that happened. They’re available this year, they’re gone next year, and so what are you doing?

Dean Barber: Yeah. Get a complimentary consultation. Let’s talk about what’s going on out there, let’s talk about your situation, and let’s help you make sure that you don’t miss any of those opportunities that are brand new this year.

Whose Responsibility is Tax Planning?

JoAnn, we’ve talked about this before, but I want to address it before we get to the Roth conversion discussion. Why don’t more CPAs do long-term tax planning?

JoAnn Huber: I think a lot of times it’s a question of, “Whose responsibility is it?” Is it the financial advisor? People may think their advisor is doing it. The CPA is like, “I don’t have all the information.” So the people come in, bring their stuff to do their taxes, and it’s really at that point just a historical document. We’re going through reporting what happened instead of looking at what needs to happen. 

Dean Barber: So the only way you can do it is if you have a CERTIFIED FINANCIAL PLANNER™ preparing the financial plan so that you, as the CPA, the tax professional, can look over that financial plan and say, “Okay, here’s your tax savings opportunities?”

JoAnn Huber: Because I think a lot of times the CPAs are looking, and they’re doing that one or two year look and saying, “Okay, do I need to incur some expenses this year for income? What do I need to do?” But it’s looking at this year, and maybe next year, and it needs to be a long-term look and say what needs to happen.

Mistakes Can  Be Made

Bud Kasper: I had that very real-life experience just in the last few weeks because I counseled with one of my clients who uses an outside CPA. There was a mistake made, and we were trying to understand that mistake. I went to them, and I said, “You need to find a new CPA,” because it was incredibly obvious. What I’m thinking is happening is no different from many CPAs. They’re so busy right now that some of the stuff has fallen through the cracks, and it costs people money.

JoAnn Huber: Well, and sometimes people don’t share everything with us that they need to. We have to have full disclosure from people and know exactly what’s going on to do the planning.

Bud Kasper: Well, this case wasn’t a disclosure issue.

JoAnn Huber: Well, yeah, that happens as well.

Bud Kasper: I understand how defensive CPAs can get from time to time, as you represented it right there.

To Roth or Not to Roth, that is the Question

Dean Barber: Perfect. All right. Let’s quit picking on JoAnn. JoAnn, talk to us about Roth conversions. Why would somebody want to Roth? I think Shakespeare said it best. To Roth or not to Roth, that is the question.

JoAnn Huber: Wow. That leaves you a little speechless.

Bud Kasper: He is so expansive.

JoAnn Huber: And to think that the Roth didn’t come into play until 1997, but yet Shakespeare was ahead of his time.

Dean Barber: Shakespeare knew it was coming. He knew it was coming. I couldn’t understand half of what he wrote anyway.

Roth Conversions

JoAnn Huber: So a Roth conversion, I think, is an excellent opportunity for people, because it allows you to choose when you’re going to pay taxes on that IRA money that’s in the deferred tax bucket. Because you can say, okay, I’m going to pay it now, I’m going to move it over to the Roth, and then let it grow tax-free. So it is a great planning mechanism to put you in the driver’s seat on what’s going to happen. With the SECURE Act, their distributions will have to come out over ten years for most beneficiaries.

Inheriting in Your Peak Earning Years

Typically, people leave the money to their kids who are going to inherit it in their peak earning years. So you have peak earning years, you add more income on top of it for ten years, well, it’s going to be taxed most likely at a pretty high tax rate. So we’re looking at a Roth conversion and saying, “Okay, do we want to do that now so that we can leave those tax free assets?” Another thing that people fail to think about is we’re not just doing it for the kids; we’re looking at the surviving spouse.

Dean Barber: That’s a really good point, JoAnn, because I think the one thing that happens a lot of times if people aren’t aware of this when you’re married and let’s say you got $100,000 of income, you’re going to be in that 22% bracket for just a little bit of that. With $22,000, or something like that of that income, you aren’t going to be in the 22% bracket; then you’ll be in 12% and 10%. Well, if you’re a single individual because you lost a spouse and you still have the same $100,000 income, about 60% of it that’s going to be taxed at 22%, as opposed to only 20% that’s taxed at 22%.

Tax Brackets and Surviving Spouses

JoAnn Huber: Right. I was looking at a couple’s situation recently. They are in the 12% tax bracket right now. When they have a surviving spouse, they’ll move up over once they start the required minimum distributions, some move up to that 22%, but the surviving spouse will be in the 35% bracket based on our projections.

Dean Barber: Isn’t that crazy? So, you got to plan for that. That could destroy a person’s lifestyle.

JoAnn Huber: Right. Do you want to pay at 12%, 22%, or 35%? And that’s what we’re looking at is saying, when do you want to pay that tax? I’ll tell you. I would rather spend it 12% or 22% than 35%. So, it’s going to create some flexibility.

Dean Barber: Can I get a zero in there?

JoAnn Huber: Occasionally, yes. We can even get some Roth conversions done at zero, depending on your situation. But it really comes back to what we were talking about earlier: having money in those different buckets and then going through and figuring out how we’re going to distribute and what planning opportunities we have. Especially during that time when somebody retires, up to age 72 is our prime time for doing many things, but we can do it before then and after.

Bud Kasper: Come on, folks, do it.

Dean Barber: The point here is that you should always focus on controlling what you can control. You can’t control what’s going on in Washington. We witnessed that in the first debate, right? We’ve been witnessing all year long, really. You can’t control COVID, and you can’t control what’s going on with the markets or interest rates or what the federal is. However, you can control your taxes in a very, very meaningful way. Learn how with a complimentary consultation

Social Security and Tax Planning

This is a wealth management show, right? America’s Wealth Management Show, as a matter of fact, and we’re here to keep you healthy when it comes to your finances. 

Let’s talk about Social Security and tax efficiency. Now, when Social Security was originally enacted, it was meant to be a tax-free source of income, but that all changed with the Tax Reform Act of 1986. The Tax Reform Act of 1986, under Ronald Reagan, imposed a tax on 50% of a person’s Social Security, and then under the Clinton administration, he raised that to 85% of your Social Security can be taxed. So you might say, well, Social Security is great, and still 15% of it is tax-free regardless of your income. Which is true, but still. Are there ways to get your Social Security tax free, JoAnn?

Social Security is CRITICAL to Tax Planning

JoAnn Huber: There are, and that’s why I would say that Social Security is a critical part of your tax planning. What can you do so you don’t have to pay tax on it? It goes back to what we were saying before. You have to have other money and that distribution strategy because it only becomes taxable, as you were saying, once you disqualify it by having other income sources.

Dean Barber: Too much of other sources. But one source that never affects it is the Roth. That’s why I said when Shakespeare wrote the thing, to Roth or not to Roth? Of course, you want to Roth, because it doesn’t affect your Social Security, right? You could have a million dollars in Roth IRA distributions and $50,000 in Social Security. Well, you’re paying zero tax, because none of it’s taxable.

JoAnn Huber: That’s the key. What can you do so you do not have to pay tax on your Social Security?

If You Don’t Have a Plan for Social Security, it’s Hard to Plan for Taxes

Dean Barber: So part of your tax plan has to be looking at what’s the Social Security strategy, right? That goes back to the whole, if that comprehensive financial plan is not done and we don’t have the Social Security strategy in place, it’s almost impossible for the CPA to do the tax plan.

JoAnn Huber: Right. Sometimes we’ll tell people, “Hold off on filing for your Social Security. I know you’re at full retirement age, and you’ve been waiting to file, but you’re going to restrict some of the tax planning opportunities we have. If you hold off a little bit, we can make it so less of your Social Security will be subject to taxes. You’re going to get that 8% growth per year. So be patient, and then you’re going to be able to keep more of your Social Security once you do claim it.”

Dean Barber: And more of your other money, too.

JoAnn Huber: Right.

Don’t Miss the Opportunities

Bud Kasper: You know, if this doesn’t help people understand that there are options that are available to you out there, and if you don’t take advantage of it, shame on you. It’s out there for you to be able to do. By the way, we’re probably one of the only shows talking about this issue. People are missing out on opportunities of how to mitigate some of the tax out of their lives.

JoAnn Huber: Which is so important, and that’s why we talk about it as much as we do. We know it can make a difference.

Dean Barber: Absolutely.

JoAnn Huber: It just takes a little bit of your time to come in and meet with us and say, what can you be doing?

The Tax Code is Growing

Dean Barber: There’s a lot you can do. The interesting thing about tax planning is there’s no book that you can read that will give you a how-to. There isn’t a “Tax Planning for Dummies”. The tax code is over 76,000 pages long.

Bud Kasper: And growing.

Dean Barber: And growing, and the problem is that it’s not a simple system. It can’t be simple if it takes 76,000 pages to explain the rules of it, right? Your job, JoAnn, is to know and interpret that tax code and help people apply it to their personal situation that gives them the benefit.

JoAnn Huber: Right. That’s why so often, I say, “It depends.” Because it is so personal, it depends on what you have and what you need your money to do. What is your plan? Once we know that, then we can look at things from a tax perspective to maximize what you get to keep in your pocket.

Did the 2017 Tax Cuts and Jobs Act Simplify Tax Planning?

Bud Kasper: Okay. So I’m going to make a statement here, JoAnn. I want you to respond to it, but I’m not trying to make this political. I’m trying to go back to what we’re talking about here. When Trump and his tax plan increased the amount of the standard deduction, was that a simplification? Did that help people in their tax planning?

JoAnn Huber: It just changed the planning that needed to be done. For some people, it did simplify it, and for others, it didn’t. It’s like any change. You just have to look at it and say, “Okay, this is what the rules are now. How do I use it to my advantage?”

Giving to Charity Can Help Big Time with Taxes

Dean Barber: What it did do was it changed how people are giving to charity, right? It increased the amount of contributions going into donor-advised funds because you can make a considerable contribution to that donor advise fund one year and get a deduction above the standard deduction. Then you can give that money to charities over time.

JoAnn Huber: Right. We see quite frequently that people are not getting a tax advantage anymore from their charitable giving, and that’s why the donor-advised fund and the bunching of things have become more prevalent, is we’re looking to say, okay, you’re charitable. Of course, we all love to get a tax saving, so what can we do so you’re getting the full tax benefit from your charitable giving?

Take Advantage of QCDs

Bud Kasper: But we did get the advantage of the QCD for people that have IRA accounts, and that’s an advantage.

JoAnn Huber: Right. 

Dean Barber: And that’s used now more than ever before.

Bud Kasper: Absolutely.

JoAnn Huber: It is. I’ve never seen it hurt somebody. It might be neutral, but it’s going to help somebody a little bit in most situations.

Bud Kasper: Another way of saving taxes.

JoAnn Huber: Right, and even if it doesn’t help necessarily, sometimes it might be a tax neutral, but it might impact the amount you have to pay for your Medicare premiums because that’s based on your adjusted gross income. So maybe we can lower it just below the threshold to keep you in that lower tier or something. So different planning mechanisms are going on with which we can use a charity to help us.

Cause and Effect of Tax Planning

Bud Kasper: And that’s why I love you, JoAnn, because you always give the cause and effect. One thing causes another one. If you don’t understand that, you might not improve your situation. So you got to know how to play the game.

Dean Barber: Yeah, and I think claiming your Social Security, when to do that, is as much a tax question as it is a Social Security maximization question because we know that there are well over 600 different iterations of how people can claim their Social Security, and the difference between the best and worst is often an excess of a hundred thousand dollars of additional Social Security income over a lifetime. But you can’t stop there. You’ve got to say, what’s the tax impact, and am I making the right decision?

Don’t Trust Online Calculators, Get Help

JoAnn Huber: Right. I get frustrated because people will go to those online calculators that look at Social Security and say, “This is your break-even point.” Well, they’re not looking, what’s the impact on my spouse? What’s the effect on my taxes? When you’re just in that vacuum, you’re missing out on the real impact of filing for your Social Security.

Dean Barber: That’s the benefit of having a CFP® prepare a financial plan, and then have one of our CPAs sit down and review it from a tax perspective to make sure that you’re making 100% the right decisions. I encourage you to get a complimentary consultation. Let’s see what we can do to help you control your taxes and keep money in your pocket and out of Uncle Sam’s. JoAnn, thanks for being with us today.

All right. You’ve been listening to America’s Wealth Management Show. We’ll be back with you next week. Same time, same place. Everybody stay healthy and stay safe.

Typical Tax-Efficient Investing Focus

Typically, one of the first thoughts people have when they think of tax-efficient investing is diversification of account types. There are three main types of investment accounts: taxable, tax-deferred, and tax-free.

Taxable accounts are accounts such as checking accounts, savings accounts, and brokerage accounts. The income generated within taxable investment accounts is taxed each year to the account owner. These accounts produce interest, dividends, capital gains, etc.

Tax-deferred accounts are accounts such as traditional IRAs, traditional qualified retirement plans, and non-qualified annuities. The income generated in these accounts is not taxed until you take distributions from the account.

Tax-free investment accounts are accounts such as Roth IRAs and life insurance. Income generated within these accounts is never taxed as long as you meet specific qualifications.

Tax Buckets

We often refer to these three types of account types as buckets. Most people would like to have all of their investments in the tax-free bucket. However, this may not be the most tax-advantaged solution. A key to being tax-efficient is determining the optimum amount to have in each of the three buckets. Having money in each of the three buckets will give you tax diversification later in life. This will provide you with flexibility later in life when you create your retirement distribution strategy.

Asset location is another common thought people have when thinking about tax-efficient investing. Asset location is how you distribute assets across the three buckets. Some assets are better to hold in taxable accounts because of tax differences, whereas a better place for others may be in tax-deferred accounts.

Tax-smart investors construct their portfolio, being aware of taxes. This tax awareness needs to consider both the taxes on the portfolio and the taxes when distributing the assets. Ideally, one should hold the least tax-efficient assets in tax-advantaged accounts such as a 401(k) or IRA. It would be best if you located the most tax-efficient assets in taxable accounts. The following shows the ideal asset location for tax-smart investing:

Taxable Accounts

  • Individual stocks you plan to hold for more than one year
  • Tax-managed stock funds, index funds, exchange-traded funds (ETFs), low-turnover stock funds
  • Stocks or mutual funds that pay qualified dividends
  • Municipal bonds, US Savings Bonds

Tax-Advantaged Accounts

  • Taxable bond funds, corporate bonds, zero-coupon bonds, inflation-protected bonds, or high-yield bond funds
  • Real estate investment trusts (REITs)
  • Certificates of Deposit (CDs)
  • Individual stocks you plan to hold one year or less
  • Actively managed funds that may generate significant short-term capital gains

By reducing the tax hit on your portfolio today, you can keep more of your money. Many people think all income is taxed the same; however, it is not. As mentioned previously, all money distributed from a tax-deferred account is taxed as ordinary income. Therefore, it is smart to put the investments that generate ordinary income in the tax-advantaged account.

The taxable account is the preferred vehicle for investments that will generate qualified dividends or long-term capital gains. This is due to the preferential tax rate for those two types of income. This account is also the preferred location to hold municipal bonds.

Bracket Management for Tax-Efficient Investing

Although it is essential to focus on asset location and account type, this is only the starting point for tax efficiency. To be truly tax-efficient, you need to look at the overall tax plan and how investments fit into that plan. Once again, the goal is to maximize the amount you get to keep by reducing the tax hit.

One important focus is bracket management. This is especially true with the historically low tax rates currently scheduled to sunset after December 31, 2025. The rates may also change under a Biden administration.

Currently, there are seven different ordinary income tax brackets – 10%, 12%, 22%, 24%, 32%, 35%, and 37%. There are also three different long-term capital gains and qualified dividends tax brackets – 0%, 15%, and 20%. The net investment income tax (NIIT) of 3.8% applies in some situations, which further complicates tax brackets.

Taking Advantage of Lower Tax Brackets for Tax Efficiency

A key component of tax bracket management is taking full advantage of the lower tax brackets. You can only accomplish this if you know your current marginal tax rate and your long-term marginal tax rate. Many people advocate deferring income as long as possible. However, this is not always the best tax strategy.

Bracket management incorporates tax planning to avoid the higher tax brackets and the net investment income tax. Paying lower taxes enables you to keep more of the investment returns. Many strategies can be employed to manage brackets. These strategies include the timing of income, deductions, retirement plan contributions, investment selection, and much more from year-to-year.

The basic idea of bracket management is to smooth the income across multiple years to keep you out of the higher tax brackets. Retirees are in a unique situation as they can control the source of their income. However, this flexibility is only available to retirees that have money saved in various tax locations. To truly control your taxes in retirement, you must make investment choices in your working years that create options. Whenever you choose where to save and how much to save, you need to be aware of both the current and future tax implications. Do the tax savings today outweigh the tax cost in the future? Do the tax costs today outweigh the tax savings in the future? It would be best if you looked at financial decisions from both perspectives.

Contributions to Qualified Retirement Accounts

One way to manage tax brackets during your working years is to contribute to a qualified retirement plan such as an Individual Retirement Account (IRA), 401(k), or a 403(b). Many employers offer both a traditional and Roth option for employer plans. In high-income years, contributions to tax-deferred plan provide a deduction which may keep you out of a higher tax bracket. In low-income years, contributing to a Roth plan may cause more income to be taxed at a lower rate. The decision regarding whether to contribute to a Roth or traditional retirement account is complicated. We discussed this in detail in a couple episodes of our podcast. Those are episodes one and two of The Guided Retirement Show. You should decide on where to save with an understanding of how the funds will be taxed when they are distributed.

Roth Conversions

Roth IRA conversions allow you to smooth your income. The keys to a successful Roth conversion strategy are to know when the right time is to do the conversion and the optimal amount to convert. Roth conversions allow you to control the year you recognize taxable income from your IRA. It is often beneficial to do smaller Roth conversions over many years rather than do one large Roth conversion. These small conversions allow you to fill-up a tax bracket. It would help if you considered Roth conversions in years when the current marginal rate is less than or equal to the projected average marginal rate during retirement. 

For example, Bob and Sally Smith currently have taxable income of about $65,000, which means they are in the 12% tax bracket. When they reach age 72 and are required to start taking distributions from IRA accounts, they will be in the 22% tax bracket. They may want to consider doing a Roth conversion of about $15,000 this year to fill up the 12% bracket.

Learn more in another episode of our podcast on what retirees need to know about Roth conversions.

Harvesting Capital Gains or Losses

Another vital tax bracket strategy is capital gain or capital loss harvesting. A gain or loss is harvested by selling the asset. The holding period of the asset makes a difference when it comes to the taxation of capital gains. Long-term capital gains are the gains that result from the sale of an asset that has been held for over one year. Short-term capital gains are gains arising from the sale of an asset that has been held for less than a year. As mentioned above, long-term capital gains receive preferential tax rates of 0%, 15%, and 20%. Short-term capital gains are taxed the same as ordinary income. When selling assets, you need to be aware of the holding period to know which tax rate will apply.

The lowest tax rate you will ever pay is 0%. You may want to harvest long-term capital gains in low-income years to fill up the 0% bracket. If you expect your capital gains to be taxed at a higher rate in the future, you may want to harvest capital gains in years where they will be taxed at a lower rate. However, as with most decisions, there is a trade-off between a lower tax rate and tax deferral loss.

Capital loss harvesting is beneficial in years with higher income. Often capital losses are harvested to offset capital gains that have been realized earlier in the year. There is no limit to the amount of capital loss that can be used to offset capital gains. However, only $3,000 of capital losses can be deducted on an annual basis against ordinary income. An unlimited amount of capital loss can be carried forward and used to offset future gains.

Retirement Distribution Strategy

When you retire, taxes are a critical component of your distribution strategy. As previously mentioned, you should have money invested in taxable accounts, tax-deferred accounts, and tax-free accounts to optimize your choices when creating a retirement distribution strategy. This distribution strategy is where you decide the order and the amount to withdraw from each of the three buckets.

A general rule of thumb is that if you retire before you have to take a required minimum distribution that you should take distributions from the taxable account first to allow the tax-deferred accounts to grow tax-deferred as long as possible. The next bucket you should tap is the tax-deferred accounts. The tax-free accounts are the last to be used. Although this may work well for many people, it may not be the right solution for you. You should work with your CPA and financial advisor to develop a forward-looking tax plan to help you determine your retirement distribution strategy.

Social Security for Tax Efficiency

Social Security is another important consideration when you are thinking about maximizing the amount you retain from your investments. Your decision on when and how to claim Social Security is most likely the most critical tax planning opportunity you will have. Whether your Social Security benefits are taxable depends on your filing status and your provisional income. The interplay between Social Security, capital gains, and other income can create some unexpected tax results. Social Security needs to be integrated with your entire plan to minimize the tax you pay and maximize the amount of money you retain.

Income Shifting

Another strategy to maximize your investment return is to shift income to a taxpayer in a lower tax bracket. You can do this by making gifts to someone who is in a lower tax bracket. For example, a parent may gift securities to a child who can then sell them and pay tax at their income tax rate. The kiddie tax rules may come into play for some taxpayers, so it is important to work with someone aware of the rules rather than just assuming it will result in tax savings. Even if the kiddie tax rules apply, you may still save taxes if you avoid the 3.8% NIIT.

Another way to shift income is to transfer a portion of ownership in a closely-held business to a family member that is in a lower tax bracket. Each owner pays tax on their portion of the business income.

Health Savings Accounts

A health savings account is one of the most tax-favored investment vehicles and a great way to save for medical expenses. A health savings account has three tax benefits. First, if you have a high-deductible health plan that qualifies for a health savings plan, then you can get a tax deduction for contributions to your account. Each year, the IRS specifies the maximum amount that can be contributed to the account. Second, any interest or other earnings on the money in the account are tax-free. Third, withdrawals from your health savings account are not subject to federal (or in most cases, state) income taxes if you use the funds for qualified medical expenses.

Charitable Giving and Estate Planning Goals

The different accounts can be used to help you plan your charitable giving and estate planning goals. If you are over age 70 ½, you are eligible to donate via a qualified charitable donation. This is a way to reduce the amount in your tax-deferred account without having to include the proceeds in ordinary income. Others may benefit from donating appreciated securities held more than one year in a taxable account to charity for a full fair market value deduction without having to pay any capital gains tax.

Another tax-saving strategy is to leave the appreciated securities in your taxable account to your heirs. They will receive a basis step-up at your death. This means the cost basis is the stock’s market value on the date of death rather than at the time of their original purchase. Your heirs can then sell the shares without realizing any gain, which is another way to avoid paying any capital gains tax.

Assets in a tax-deferred account do not receive a step-up in basis, and distributions from the tax-deferred account will be taxed as ordinary income. If you want to leave a portion of your estate to charity, the best type of account to leave is a tax-deferred account. A qualified charity does not have to pay any income tax on the funds from a tax-deferred account.

The most favorable tax account to leave your heirs is a Roth IRA. Qualified distributions from these accounts are tax-free to your beneficiaries.

Thinking Beyond Tax Efficiency

Pro-active tax planning can help you reduce the drag that taxes have on your investment returns. It would be best if you thought beyond tax-efficient investing when implementing these tax strategies to help you keep more of your money.

JoAnn Huber, CPA, CFP®, PFS

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The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.