Picking good investments is only half the battle when investing and growing wealth. The other half is maximizing your gains through tax-efficient investing.
For most of us, taxes are our biggest lifetime expense. And the higher your current income tax rate, the more crucial it is that you focus on proper tax planning. That’s why tax planning needs to remain top-of-mind, especially if you are a high earner.
Changes in the U.S. tax code happen frequently, and so should your planning. Treat proper tax preparation as a year-round venture, rather than something you only address during tax season.
Though you won’t be able to avoid paying taxes altogether, you can take steps to reduce the single greatest expense you have. There are plenty of options for tax-efficient investing if you bring home a big check. But, you have to be diligent enough to pursue them or work with a Fiduciary Financial Advisor who can guide you.
So, how can you take advantage of the new tax laws? What tax reduction strategies exist for high-income earners? Keep reading to learn more.
1. Contribute to tax-advantaged accounts
If you’re eligible to contribute to tax-advantaged accounts, you can reduce your current and future taxes.
- Tax-deferred accounts, like Traditional IRAs and Traditional 401(k) plans, are funded with pre-tax dollars. You may be able to deduct your contributions, which reduces your taxable income. You’ll pay taxes when you withdraw your money in retirement.
- Tax-free accounts, like Roth IRAs and Roth 401(k) plans, are funded with after-tax dollars. Your investments will grow tax-free, and qualified withdrawals in retirement are tax-free, too.
Backdoor Roth IRA
In 2021, if you earn $140,000 or more as an individual or $208,000 or more as a couple, you cannot contribute to a Roth IRA.
If you earn too much to contribute to a Roth IRA, you can take advantage of the convenient loophole that is the Backdoor Roth IRA. It’s a perfectly legal way to convert a Traditional IRA to a Roth IRA regardless of your income.
Here’s how it works:
- You can contribute up to $6,000 per year (or $7,000 if you’re 50 or older) to a Traditional IRA (or open a new IRA).
- As soon as that money posts to your Traditional IRA account, you can convert that IRA into a Roth IRA. (If you don’t already have a Roth IRA, you’ll open a new account during the conversion process.)
Keep in mind: Only post-tax dollars go into Roth IRAs, so be sure you have enough cash on hand to pay taxes on the conversion. Additionally, if the money in that Traditional IRA has been accruing investment gains for some time, you’ll also need to pay taxes on those gains at tax time.
A backdoor Roth IRA is not a tax dodge—in fact, it might even incur higher taxes when it's established—but you’ll enjoy the future tax savings of a Roth account.
2. Make tax-efficient investment choices
Did you know that some investments can carry tax benefits?
For instance, income earned from municipal bonds is generally tax-free at the federal level. If you buy municipal bonds in your state of residence, it may even be state and local tax-free.
Another example of a tax-efficient investment is a tax-managed mutual fund, whose managers work specifically and actively for tax efficiency.
You can also choose to invest in index funds and exchange-traded funds (ETFs) that passively track long-term investments in a target index. (Because the securities in the index funds aren’t traded as frequently as the actively traded mutual funds, they generate lower short-term capital gains distributions.)
Always check with your Fiduciary Financial Advisor and Tax Advisor to make sure you understand the tax implications and features of your investments.
3. Match investments with the right account type
By holding your investments in the right types of accounts, you can take advantage of all the potential tax benefits without increasing your tax liability.
The best location for your assets depends on a number of different factors including:
- Financial profile
- Prevailing tax laws
- Investment holding periods
- The tax and return characteristics of the underlying securities
Investments that regularly generate taxable income may be better held in tax-advantaged accounts—like a Traditional IRA—to gain the most potential tax benefit.
- Individual stocks you plan to hold for less than a year
- Actively managed stock funds that generate substantial short-term capital gains
- Taxable bond funds, inflation protected bonds, zero-coupon bonds, high-yield bond funds
- Real estate investment trusts (REITs)
Investments that are tax-neutral are better suited for a taxable account, like a brokerage account. Why? If your investments don't generate high taxes, there is less of a need to defer them. (Additionally, you can capture tax losses on poorly performing investments sold at a recognized loss.)
- Individual stocks you plan to hold for at least a year
- Tax-managed stock funds, index funds, exchange-traded funds (ETFs), low-turnover stock funds
- Qualified dividend-paying stocks and mutual funds
- Series I bonds, municipal bond funds
Of course, there may be instances when you need to prioritize some other factor over taxes. For instance, a corporate bond may be better suited for your Traditional IRA, but you may decide to hold it in your brokerage account to maintain liquidity.
Your Fiduciary Financial Advisor will help you develop a tax strategy that gives your accounts the best opportunity to grow over time.
4. Focus on tax diversification
By diversifying the types of accounts you maintain, you can minimize your tax burden in retirement. Different types of accounts are taxed in different ways.
- Traditional IRAs offer tax-deferred growth potential
- Roth IRAs offer the potential for growth that won't be federally taxed if account owners meet requirements for qualified distributions (state taxes may apply)
- Brokerage accounts offer taxable growth potential
Examples of tax diversification
- Steve is eligible to take tax deductions in retirement, and needs taxable income in order to take advantage of them. Withdrawals from a traditional IRA count as taxable income, so Steve could withdraw only enough to offset his eligible deductions, and then draw the rest from his Roth account. He won’t need to pay taxes on his Roth distributions, which are federally tax-free (and may be state-tax-free, too.)
- Linda has taxable accounts to draw from in retirement. Thus, she can draw them down and allow her Traditional IRA assets to continue to potentially grow tax-deferred until she must take her RMDs, or required minimum distributions. (She still may defer her first RMD until April 1 of the year she turns age 70 ½ or 72, as applicable—however, she’ll be required to take two distributions within that year.)
- Frank has been in the workforce for 10 years. He opened a Roth IRA at Prosperity Financial Group, because he anticipates his future tax rate will be higher than his current rate. Money contributed to a Roth IRA is taxed at current rates, and qualified distributions are free from federal tax—and also may be exempt from state tax.
Spread your contributions among different account types to help manage your tax liability in retirement.
5. Tap into the triple tax benefits of your Health Savings Account (HSA)
A Health Savings Account (HSA) is an underrated investment account. It acts as both a savings and investment account that gives you three tax breaks:
- You contribute pre-tax money
- You enjoy tax-free growth
- You withdraw from it, tax-free, for qualified medical purposes
In order to qualify for an HSA, you must have a high-deductible health plan. However, once you enroll in Medicare, you can’t contribute to an HSA since it’s a high-deductible plan. But you can still use the money you’ve saved!
Unlike the Traditional 401(k) or IRA, you aren’t required to take required minimum distributions (RMDs). You can withdraw money on your own schedule.
In the short term, you can use funds on qualified healthcare expenses, such as doctor’s visits and prescriptions.
In the long term, you can use your HSA to help cover the cost of medical expenses in your later years. The average couple retiring today will need $295,000 for medical expenses in retirement—not including long-term care!
To use your HSA as a “Health IRA,” simply contribute a minimum amount (usually $1,000 to $2,000). Then, start investing that money into mutual funds inside the HSA.
Once you reach retirement age, you can take tax-free distributions for qualified health expenses. Or, you can take money out of your HSA and pay income taxes—just like you would with a 401(k) or traditional IRA—and spend it on whatever you’d like.
6. Add flexibility with brokerage accounts
While retirement accounts like 401(k)s, 403(b)s, and IRAs have tax advantages, they often have limitations too. You may have a subpar 401(k) investment menu, or you may have already hit the contribution limit of your tax-favored plans.
A brokerage account gives you flexibility in:
- Timing of withdrawals. You can take money out at any time for any purpose without having to pay income taxes or penalties. This flexibility is important if you want to retire early and need an income stream.
- No required minimum distributions. You get to decide when and how much you want to withdraw.
- Types of investments. You can purchase all kinds of investments: stocks, bonds, mutual funds and exchange-traded funds (ETFs).
Open An Account
You can open a taxable investing account directly with Prosperity. You can even set up automatic withdrawals from your bank into that investment account each month.
7. Harvest losses to offset gains
Tax loss harvesting is the practice of selling an investment for a loss. By harvesting (realizing) a loss, you offset your investment gains each year, thus reducing your income tax liability.
If your investment losses exceed your gains, you can use them to offset up to $3,000 of earned income each year as well, with additional losses carried forward to future tax years.
As a high earner, a higher long-term capital gains tax rate plus the additional 3.8% Net Investment Income Tax can make "tax loss harvesting" even more valuable.
8. Invest in real estate as a tax shelter
There are several tax benefits to investing in real estate, including:
- Depreciation, which shelters income from tax
- Avoiding FICA (payroll) tax on rental income
- No tax on appreciation, if you buy and hold for many years
- Capital gains tax at lower rates
- 1031 exchanges (like-kind exchanges) of real property
- Installment sales for income & deferred taxes
- As an estate planning tool—realizing a loss when you sell real property shortly after it’s inherited which can offset other gains
Real estate investments are the most hands-on and time-consuming of your investing options. Remember to talk to an insurance agent about any liabilities you might have, especially if you invest in rental property. Consider purchasing land, like on the outskirts of an up-and-coming city, and be sure you’re working with a top-notch real estate agent when you’re ready to buy.
We Can Help
Remember that tax-efficiency isn't the only consideration for your investment decisions. Each investment can help you pursue your diversification, liquidity and overall investment goals—at your preferred level of risk. Tax efficiency is simply an element to help you select your best investment options.
Especially as a high-income earner, it’s valuable to work with a Fiduciary Financial Advisor to determine your best investing options based on your income and goals. These decisions are too important to go it alone.
If you’d like to learn more about optimizing the tax-efficiency of your portfolio, please fill out the form below and we'll get back to you shortly. We look forward to hearing from you.
DISCLAIMER: Prosperity Financial Group does not provide legal or tax advice. However, we can connect you with trusted legal and tax professionals regarding your individual situation. Be sure to consult with your professional Tax Advisor before making decisions that will affect your taxes. Advisory Services offered through Prosperity Financial Group, Inc., an Independent Registered Investment Advisor. Securities offered through Fortune Financial Services, Inc. Member FINRA/SIPC. Prosperity Financial Group, Inc. and Fortune Financial Services, Inc. are separate entities.