Tax Efficiency Part I: Income Tax

Disclaimer: This article discusses topics at the nexus of investments and taxes, but does not provide and should not be construed as providing tax advice. Please contact your CPA or tax professional for guidance on tax-specific issues.
Note: Please see my video discussion of this topic below or other videos on my videos page. You may also want to read my PDF guide entitled Sensible Strategies to Reduce Your Taxes or other articles regarding retirement accounts on my Research page.

Many (most?) people I encounter tend to focus on investing and returns. Of course, this is an important part of financial planning. It can be fun and many people enjoy (or are addicted to?!) taking active roles in their portfolios.  However, investing can be a double-edged sword. Indeed, higher returns often involve higher risk, most people underperform the broader market (see Sharpe’s Arithmetic), and active portfolio management can trigger unnecessary capital gains. Note: These are three key reasons why I tend to lean toward low-cost index funds and ETFs (exchange-traded funds).

Unfortunately, these same investors rarely have a solid grasp on broader financial planning and how it can lower their taxes. So that is the point of this article. In particular, I will provide a broad description of strategies used to minimize taxes on your income. I will discuss strategies to lower what I call investment-related taxes (i.e., taxes on capital gains, dividends, and interest) in another article down the road.

A general example

Before delving into some of these strategies below, I would like to introduce a simple example. As of this writing, it is the last week of 2021 and Jane Doe has the opportunity to make $100,000 by doing two different projects for $50,000 each. We will assume she has no other income this year and does not anticipate any next year either.  We will further assume she has the ability to choose when she completes these projects. This translates into three options:

  1. Complete both projects immediately and earn $100,000 in 2021
  2. Relax until the new year, then complete both projects and earn $100,000 in 2022
  3. Complete one project immediately and one in 2021 so she earns $50,000 in each year

From a tax perspective, the best option is #3. This is due to the progressive tax system we follow in the United States. If she earns $100,000 in a single year, many of those dollars will likely be taxed at a marginal rate of 24% even after her standard deduction. However, if she splits it up, she would get the benefit of applying her standard deduction twice and never climbing higher than the 12% bracket.

While this is a single hypothetical example considering just two years, the idea generalizes throughout one’s lifetime. The idea is to use different strategies in order to level or flatten out our income throughout our lifetimes. This will help us minimize the amount of income that pokes up into higher brackets and incurs higher marginal tax rates.

The most popular tool: Retirement accounts

I think the most popular strategy to lower your income taxes is to contribute to your traditional (i.e., non-Roth) retirement accounts. By making contributions to these retirement accounts, you effectively avoid (albeit only temporarily) paying income tax on those earnings. So your tax bill in the current year is reduced.

The money you contribute as well as its growth will ultimately be taxed as income when it is taken out. Therein lies the key benefit; most people will be in lower tax brackets during retirement since they are no longer working. So the tax rate on this income will very likely be lower than if it were paid in the year it was earned.

This can often result in a 10-20% lower tax rate – especially when optimized during retirement (see the section below on Roth conversions). This strategy helps to level one’s income (and hence income tax) throughout their lifetime and follows the logic of the example highlighted above.

Another benefit of using retirement accounts is that they impose no taxes any dividends, interest, or portfolio rebalancing (i.e., capital gains). If the same investments were made in a normal, taxable brokerage account, then these types of taxes would have applied – thus reducing the benefit of compounding and overall growth rate.

Maximizing retirement accounts

Given the significant benefits described above, why would any choose not to defer more their taxes until retirement? Unfortunately, one common reason is people wanting or needing the money now. Even when someone wants to contribute more to their retirement accounts, there is another reason: contribution limits.

Depending upon what type of retirement plan you have (e.g., 401K, 403B, IRA, etc.), there will be limits on how much you can contribute. For example, the maximum contribution to a standard 401K is $19,500 in 2021 for workers aged 49 and under. It is also worth noting that employers often match some or all of their employees’ contributions and this makes the economics on retirement contributions even more compelling.

Many prudent savers max out their contributions to their 401K but it is also worth noting that you may also make contributions to (individual retirement accounts (IRAs) outside of their employer plans. However, income limits may apply and impact the deductibility of those contributions. So you should check to make sure your retirement contribution strategy makes sense for your situation. The next section touches on one special case: high earners.

Roth accounts and high earners

Roth retirement accounts are another option available to many of us. These are similar to the retirement accounts above except:

  • These contributions are still taxed in the current year
  • Money grows tax free (i.e., no tax when money is taken out – unless the tax code changes!)
  • Required minimum distributions do not apply
  • Different limitations apply

The discussion above involved deferring income tax until you are in a lower tax bracket during retirement. However, if you are a higher earner and the math works out a certain way, then Roth accounts may be sensible. For example, if you are stuck in higher brackets even during retirement, then there may be no benefit to deferring income tax.

In this case, you might consider how the tax rates (not tax brackets) might be different down the road. In my experience, most people (including myself) expect taxes to go up – especially relative to the current (2021) rates we enjoy now on the back of Trump’s Tax Cuts and Jobs Act (TCJA).  However, it is also important to consider the potential benefits stemming from no RMDs. I find this is an often-ignored topic. So I have devoted much research to this topic (e.g., the articles here and here).

Note: Income limits prohibit many of the people who would benefit most from using Roth contributions. However, under current (2021) tax law, there is another way for higher earners to get money into Roth accounts. The method is called the backdoor Roth strategy. While I will not go into the details, the basic idea is to make nondeductible contributions to retirement accounts and soon after convert them to Roth accounts.

Optimizing further: Roth conversions

Some people think it is best to leave their IRAs alone for as long as possible to maximize tax benefits. However, this is often not the optimal strategy. There is another powerful strategy we may be able to use in order to level one’s income further during retirement.

For many, there is a period between when someone retires or semi-retires (i.e., stops or reduces their earning) and when they start taking their full Social Security benefits or are required to distribute money from their retirement accounts (i.e., RMDs). In other words, there may be a period where they temporarily find themselves in lower tax brackets.

These situations open the door to making Roth conversions. That is, one can pay taxes and convert parts of their traditional retirement accounts to Roth retirement accounts (e.g., traditional IRA to Roth IRA). This allows them to pay taxes on some of their retirement balances in lower brackets but not lose out on the other retirement account benefits (i.e., no tax on dividends, interest, or capital gains from rebalancing). Again, this facilitates the general idea of leveling out their income throughout retirement in order to minimize poking up into higher tax brackets.

Determining the optimal amount of Roth conversions is a complicated task that involves many variables:

  • Size of retirement accounts
  • Spending needs
  • Current + future tax rates
  • Beneficiary tax brackets
  • Longevity expectations
  • Social Security elections
  • Tax credits + eligibility for various subsidies (e.g., affordable care)
  • IRMMA (investment-related monthly Medicare adjustments)
  • NIIT (net investment income tax)
  • Taxation of Social Security (watch out for the torpedo!)

Accordingly, I strongly advise utilizing a financial planner who uses financial planning software that is devoted to this purpose. I prefer Income Solver due to its superior calculation engine even if its interface and reports are less glamorous than other packages.

Unfortunately, I find many advisors opt for planning software packages that are easier to use and create more aesthetic (interactive) reports to show to their clients. Moreover, I believe it is also important for financial planners to augment software output to address areas the software does not (e.g., disclaiming and beneficiary strategies – see my video discussion of this topic on my videos page).

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