5 Tax Strategies to Help Save Money
In this week’s podcast episode, Valorie Escobar, senior wealth advisor, and Mike MacKelvie, wealth advisor, walk through 5 tax planning strategies and opportunities like Roth conversions, backdoor Roth IRA conversions, asset allocation, tax-loss harvesting and making qualified charitable contributions. They’ll also discuss considerations for each of these strategies and why it’s important to consult with your wealth advisor.
Mike MacKelvie: If you were living in the North and making over $600 in 1862, you might be a little upset. For the first time in American history, you’d have to take a percentage of your income and pay it to the federal government. The tax is simple: 3% on incomes between $600 and $10,000 and 5% tax on anything above to help pay for the Civil War. Today, in 2022, the landscape is a little different. Thirteen hours—that’s the average tax filing time for an American citizen. Put differently, your significant other could watch the entire “Star Wars” trilogy, the original “Star Wars trilogy,” twice and still have time to laugh at you as you try to find the receipt from Home Depot for the kitchen remodel that you’re trying to write off.
The tax code is a little longer than a few paragraphs today. Its estimated length is in the thousands of pages that is, which would stack it all the way to the ceiling if it was sitting on your desk. That’s complexity. And where there’s complexity, unfortunately, there’s often paralysis. But there can also be opportunity. And in this episode, I’m joined by Valerie Escobar to help walk through five tax planning strategies and opportunities.
Valerie Escobar: Absolutely. It’s good to talk to you, Mike. Excited to point these points, too, to our audience. And let’s go ahead and dive in and with our first one, the Roth conversion. What this strategy does is it moves money from your traditional IRA, take it out of the traditional, move it into your Roth. This will require that there’s taxes paid. So don’t get shocked when there is a big tax payment due at the end of the year. That’s the point. But what it does is allows money to grow within that Roth and never be taxed again.
So that’s the beauty of the Roth conversion. What we want to do is time it during low income years. So maybe there’s a gap year, maybe you’ve retired, you haven’t started Social Security yet, you haven’t started your required minimum distributions. Those are the ideal years in which you want to do your Roth conversions. Another point is that to get the most bang for your buck is to not withhold taxes from the IRA distribution. So you take out 10,000 from your IRA, put the whole $10,000 in your Roth, but don’t forget there’s taxes, of course. And so you need to plan on how you’re going to pay for that liability outside of touching either of those accounts.
Mike: I mean, you’re exactly right, the gap years. Those maybe, just for whatever reason, lower-income years, and then, again, sometimes there’s that misconception that floats around that you have to convert the entire Roth IRA—not always the case. You can convert whatever portion of it you’d like, but definitely a highly effective strategy, something we modeled out for a lot of people. The next strategy, backdoor Roth IRA, is in a form a little bit of a Roth conversion as well, but backdoor Roth IRA, for whatever reason, it got this shady, kind of slimy-sounding name. Sounds like you’re deceiving or being dishonest with the tax man, you’re not. It’s completely…
Valerie: Although we’re not really are that concerned about trying to take advantage of the tax system.
Mike: Yeah. I mean obviously, if you see an advantage, there’s tax planning and there’s tax evasion. Those are obviously two different things, right?
Mike: And you want to be cognizant of a few different contingencies with this. But again, just to give you a quick overview on how it works, you contribute money first to a non-deductible IRA, you then move that money to a Roth IRA by way of conversion. This gets you around being phased out of a Roth IRA. So, if you’re maybe a high-income earner and you’ve been phased out of just contributing to a Roth IRA, you can contribute to this non-deductible IRA then convert it to a Roth IRA and get around that issue. But, again, I mentioned there’s contingencies here. Oddly enough, the tax man did figure out that there were high-income earners were maybe skating around some of these tax laws and getting money into the Roth IRA.
And so, one of these contingencies is the aggregate rule. So if you have any existing IRAs, SIMPLE IRAs, SEP IRAs, traditional IRAs, what they’ll do is they’ll look at a portion of your entire IRA portfolio, they’ll say, “Okay, hey, part of that has to be taxed.” It’s a little confusing, but again, if you have existing, SIMPLE, SEPs or traditional IRAs, you can be subjected to further taxation on this conversion. Normally what would happen is it’s just post-tax money that you’re contributing to this non-deductible IRA, you converted over to this Roth IRA. There’s no taxes if you didn’t have any other existing IRAs, but if you did have existing IRAs, you might be subjecting yourself to some additional taxes on top of that.
So obviously, a consideration there for anybody that’s thinking about, “Hey, do I want to take advantage of this?” But I would say there’s a flow chart that maybe helps because it does get a little complex as to whether or not you’d want to do it. If you’re making less than the phase-out amount for the Roth rate, that is you can just contribute to a Roth IRA, why would you do this? You would just obviously contribute to the Roth IRA. So first, if you’re below that phase-out number for Roth IRAs, just contribute to a Roth IRA. There’s no point in going through all this hassle.
If you’re above that and you don’t have any existing traditional SEPs or SIMPLEs, this is obviously tax that likely makes sense to execute and likely makes sense to execute that conversion almost immediately after contributing to that non-deductible IRA. So some things to think about with it, Valerie.
Valerie: Absolutely. And with our clients, we like to keep things as simple as possible. So another piece that we do is that we don’t invest the non-deductible IRA contribution. We just let it sit at cash, then we can convert it. Therefore, there’s no gains that are taxable either. So, just something else to lower that CPA bill as well.
Mike: Good point.
Valerie: So our next piece is asset location. So let’s say we’re going down the road, you’ve talked to your financial planner. You’ve decided that 5% rate of return is going to get you where you need to be to meet all your financial goals. And in order to get that 5%, we’ve decided a 60/40, plain old vanilla 60/40 allocation where 60% goes to stocks, the other 40% is fixed income. So now where do we invest it? Where do we put this money? So we have our taxable accounts and we have our qualified accounts, which means tax shelter or IRAs or Roths.
We can do it very simplistically in that we put that same 60/40 lineup of investments in all of those different accounts, but to get our little extra oomph out of our tax efficiency here, what we want to do is put our least tax-efficient investments in our qualified tax-sheltered accounts. So, what’s that Michael? You want to know which are the investments that are least tax efficient?
Mike: That was the next piece. Yeah, go ahead.
Valerie: So we’re talking about anything that pays a dividend or has some kind of income. So bonds, they will have yield. That’s the whole reason people buy them. We also are looking at real estate, REITs, those will pay a yield and even some of our stocks that pay our dividends. So those are investments you want to put in those qualified buckets. And then at the top where we’re looking at real tax efficient, it’s going to be stocks that are more growthy and that we’re looking at capital gains-type of growth to go with that. So that’s our taxable stuff. But again, consult with your financial advisor just because it will put you in a situation where your taxable accounts are going to be the most aggressive. And if you are needing a second bucket to dip into for emergencies, you want to make sure you have a safe bucket as well. So just to caveat that.
Mike: I mean, obviously some great points there and there’s all these different tools, all of these different investments, these different assets and they come with different taxation. So I remember there was a Vanguard paper that actually came out in the past that talked about strategically positioning your assets and how that was a part of what’s called the advisor alpha. So essentially, what percentage of just overall growth people missed out on, because they maybe didn’t have the right assets just in the right buckets. Not necessarily they were bad, they just maybe weren’t in the right bucket. So definitely some things to think about there. Now, tax-loss harvesting. Point number four here, it sounds a lot better than the backdoor Roth IRA. For whatever reason, it got the good name, it’s got harvest.
Valerie: Yes, farmers, we all love farmers, and they harvest.
Mike: You get to harvest your loss. I mean, Valerie’s out there in Kansas. She feels good about it. She feels okay about it.
Valerie: I give it my thumbs up.
Mike: So tax-loss harvesting—it’s essentially the selling of securities at a loss to offset some gain. And you’re limited on how much you can offset from a short-term standpoint each year at $3,000. But effectively what you’re doing here is a lot of times just deferring your taxable gain. So a lot of times, investors at the end of the year will maybe look to capture some of their losses. They’ll go look at their portfolio and say, “Okay, hey, I got this stock at a loss. I got this stock at a loss. I’ll sell those, I’ll offset and sell some of my other stocks at a gain.”
A couple pieces I think are worth noting here. So I’ve found that people tend to overestimate tax deferral. So the actual benefit of tax deferral, it is a benefit. But it’s not that large of a benefit maybe as your perception might think. And I think part of the issue is, “Well, I’m not paying taxes today. That feels pretty good.” So you feel like you’re getting a very good benefit today, you’re realizing that benefit today. But the reality is if you stay in the same tax bracket for the rest of your life, there wouldn’t be as big of a benefit maybe as you might think.
And there’s a couple different white papers that are written around this, but I would say that the real benefit here is if you do believe that you’ll be in a future lower-income bracket. So again, as Valerie touched on those gap years, so if you’re maybe having an early retirement, you have a sabbatical, whatever it might be, you can then look to realize some of these gains that you’ve deferred in a low-income year, and maybe you’re in the 15% capital gains bracket. When you do that, maybe you’re in the 0% capital gains bracket when you do that.
So obviously, that’s a benefit. Now, again, if you just deferred for your whole life then you died, well, you get a step-up in basis. So I guess that’s a benefit, too, but you’re probably not banking on death as the main primary source of your strategy for this.
Valerie: You don’t usually implement death as your strategy.
Mike: I mean, again, there’s some contingencies that come with that, some considerations. But again, I see it as something that if you believe you’ll be in a lower-income bracket in the future, it can maybe justify deferring some of those gains, which essentially what a tax-loss harvest is.
Valerie: Yeah, absolutely. And then we do as planners have a bad habit of making money for our clients, and while we want to de-risk and sell off some of those big gains, so that tax-loss harvesting is perfect. It gives us some tax credits. It’s not actually a credit, but it’s sort of a coupon that we can redeem for offsetting those capital gains taxes.
Mike: And one last note on that, too, you want to avoid wash sale.
Valerie: That’s a great point.
Mike: Sometimes people caught up in this. Actually, I had a friend of mine that just said, “I got this bill that says I don’t need to write off a certain amount of my taxes this year that I thought I was going to be able to do.” Again, if you sell a substantially identical security within a 30-day period and go and buy it, the same stock, let’s say, or substantially identical security, which would be the same an A share and a B share of the same mutual fund, you can get dinged with the wash sale rule, which means you just negated the whole strategy. So one last piece, just to add onto that.
Valerie: Yep. Agreed. All right. And now we’re on that talking about farmers and harvesting, let’s talk about charitable giving and other stuff that makes people feel good. Giving to charity is something that is not only beneficial to our society, but it can also help with our taxes. One of the simplest ways is called qualified charitable distributions. This is when you are over 72 or 72, and you are required to take minimum distributions from qualified accounts, so your IRAs, 401(k)s, things like that, that is required by the government. And the reason why is they don’t want you to keep money in there forever. And they also want us to pay the taxes on it. But you can actually avoid paying those taxes if you give that required minimum distribution to a charity. So pretty easy way, you don’t get to keep your money, but at least you avoided paying the taxes on it.
And a second thing that you might do is if you’re not quite 72, you can give to charities and count that as a deduction. But if you are itemizing, you need to have a certain amount before to meet that threshold. And so to help with that is, let’s say we’re going to bunch our charitable gifts into one big year. I know that you’re big into the Hedgehog Society. And so you give a lot of money to them.
Mike: Big Hedgehog fan.
Valerie: And so those Hedgehogs, they don’t need $10,000 a year, over five years. Let’s just give them the $50,000 all in one year, and then therefore you’ll get a lot more benefit out of it on your taxes.
Mike: So grouping, obviously those donations, and sometimes there’s this fallacy that exists out there. And I know Valerie and I have talked about this where you maybe think, well, I’m just avoiding all these taxes. I’m ending up at a net gain by donating to a charity. Unfortunately, that’s not the case. So it’s not like you can give all this money to a charity and walk away with more money. There’s benefits in the way that you go about it so you can essentially avoid more taxes strategically. But you’re not ending up at a net gain by donating to a charity, really, in almost virtually every situation that I’ve ever seen.
So again, obviously some different things to think about here. Some different strategies to help, obviously, with this complexity. You think about this tax code, thousands of pages in length, that typically means opportunity. So hopefully you found this helpful. As always, make sure to hit that ‘Subscribe’ button. If you’re listening on Apple Podcast, Spotify, YouTube, hit that ‘Subscribe’ button to follow along for more content from industry professionals here at Mariner Wealth Advisors.
Valerie: Thank you for joining us on this episode of Your Life Simplified. We’ll see you next time.
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