Tax Planning For The Three Stages of Your Financial Life

In this blog post, we'll show you how to lower your tax burden in any season of life and what steps to take in each of the three stages of your financial life: wealth accumulation, preservation, and distribution.

June 22, 2022

In times of uncertainty, it's in our DNA to want to take action. It's called the fight-or-flight response. As a result, successful investing will always be counter-intuitive and challenging for most people. Regarding long-term investment, evidence and research continue to favor a strategy that rewards patience and discipline over action or response. 

Fortunately, not all parts of wealth management and tax planning involve resisting your wiring. When it comes to tax planning, there are numerous opportunities to seize the bull by the horns and act in all stages of life.

Any stage of life

Regardless of their stage of life, we always advise our clients to invest in a tax-efficient portfolio when possible. The three techniques for structuring your portfolio in the most tax-efficient manner are as follows: 

1) Vehicle selection (mutual fund vs. exchange-traded fund), 

2) Turnover minimization and;

3) Asset Location (e.g., 401k vs. Taxable Brokerage Account).

Second, we recommend that you assess your portfolio on a yearly basis for tax-loss harvesting (TLH) opportunities. The process of selling a security at a loss and replacing it with another security with comparable features is known as TLH. You can deduct up to $3,000 from your regular income and carry the remaining losses forward to use in the future if you capture, or "harvest," a loss.

Stage 1: Wealth Accumulation

One crucial tax planning strategy for people in the workforce is to take advantage of the tax-deferred savings opportunities offered by their employer's 401(k) plan or Roth 401(k). You can defer up to $20,500 in 2022 ($26,000 if you're over 50). Depending on your employer, you may be able to put more money into a Roth 401(k) after taxes.

If your financial position allows it, the next step is to contribute to an IRA annually. If your financial position allows it, the next step is to contribute to an IRA annually. The annual maximum will increase to $6,000 in 2022 ($7,000 if you're over 50). 

Many people are surprised to learn that even if they earn a lot of money, they can still contribute to an IRA. But there's a catch: your IRA contributions may or may not be tax-deductible, depending on your income level. If you can make a tax-deductible contribution, that's fantastic – you just saved $6,000 on your taxes! But what if your income is too high and contributing this year won't help you save money? It's possible that you could benefit from a backdoor Roth IRA.

Backdoor Roth IRA

While the term may look suspicious, the strategy is legitimate and, when applied appropriately, extremely beneficial.

  • High-income people cannot contribute directly to Roth IRAs due to income restrictions.
  • Anyone can make an average IRA contribution, but income restrictions limit who is eligible to deduct the contribution amount from their tax return.
  • When converting traditional IRAs to Roth IRAs, there are no income restrictions.

A Backdoor Roth IRA takes advantage of a loophole that allows high-income individuals to develop after-tax assets by converting non-deductible IRA contributions to Roth IRAs. Unfortunately, because we're working with the tax code, it's not as straightforward as it seems. When you convert IRA assets to a Roth, you don't pay taxes on the portion of the money you've already paid (i.e., non-deductible contributions), but you do pay taxes on the IRA assets that haven't yet been taxed.

As a result, a high-income earner with no other IRA assets is the ideal candidate for a Backdoor Roth IRA. Suppose you have a substantial rollover IRA from a previous 401(k). In that case, the Backdoor Roth IRA loses its appeal because you will be paying higher rates on a significant amount of the conversion. Remember that the fundamental goal of any Roth decision is to finance the Roth vehicle at a lower marginal rate than the funds will be taxed at when they are distributed during RMDs. 

Stage 2: Wealth Preservation

At this point, you begin to consider retirement planning following years of work experience. You've been putting forth a lot of effort to save money. Now is the time to reassess all of your investments and determine what you want to get out of them once you retire.

With accelerated stock options, bonuses paid out, sabbaticals paid in cash, and other benefits, many employees may face an inflated tax obligation when it comes time to retire. 

Front-loading charitable giving with a Donor Advised Fund is a great strategy to decrease your tax burden in high-income years for charitable individuals (DAF). A DAF is a charitable giving account that accepts both securities and cash donations. The donor obtains a tax benefit in the contribution year, and the donated assets grow tax-free in the account until they are gifted to a qualified charity of their choice.

The added benefit is that you can give highly appreciated stocks and avoid paying capital gains taxes!

Stage 3 – Wealth Distribution

When your wages stop coming in, and Uncle Sam isn't forcing you to take RMDs at 72, there are ways to take action by "forcing" distributions out of your tax-deferred accounts at lower tax rates than you'll be in once RMDs start. Many people may be happy with paying no taxes for a few years because of the string of $0s in the tax row. They miss an excellent opportunity to lower their lifetime tax liability by not "pushing" money out. How? Because IRA distributions are taxed at ordinary income rates, people with considerable tax-deferred assets will find themselves in higher tax brackets once RMDs start.

If you agree to intentionally reduce your tax-deferred assets before reaching the age of 72, but you don't need the withdrawn cash to live on, a Roth Conversion is an option to consider. You can effectively minimize your lifetime tax bill by transferring assets to tax-free Roth buckets at lower marginal rates than they will be taxed at later. There are no restrictions on how much you can convert, though partial conversions are usually more cost-effective.

Source: Financial Planning

Let's say: 

Amy has significant tax-deferred assets and will almost certainly be at or above the 22% tax rate in retirement. As a result, she'll want to concentrate on the 12% bracket. 

During year-end planning, she assesses her base income (Social Security, salary, pension, and other deductions). She decides to convert $46,250 from her rollover IRA to her Roth IRA to produce additional income for the calendar year. By effectively taking action and targeting the 12% tax band, she has reduced her tax-deferred bucket and, more importantly, her lifetime tax burden.

The wealth distribution stage differs from the other stages because it is more conscious than calculated. It's essential to keep in mind that how you distribute your money will affect how long it lasts. You can prepare for this stage by speaking with a wealth manager.

We enjoy tax planning at Vincere Tax and are affiliated partner, Vincere Wealth, because there are always opportunities, no matter what stage of life you are in. Furthermore, because the rules are constantly changing, we must always be on our toes. While we stand by the saying, "Don't let the tax tail wag the dog," we believe the optimization strategies discussed above enable our clients to decrease their tax liabilities while allowing them to focus on what matters most: aligning their resources with their goals.

If you have any questions about the strategies discussed or want to work with Vincere, please feel free to reach out to us here. 

This material was prepared for informational purposes only and is not meant to provide tax, legal, or accounting advice. Before engaging in any transaction, you should consult your own tax, legal, and accounting professionals.

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