By Echo Huang, CFA, CFP®, CPA
When I worked as a tax CPA for KPMG in the late 90s, I served many corporate executives and wealthy families as their senior tax specialist and prepared many individual income tax returns, trust returns, and gift tax returns. Now I use that knowledge and expertise to help my affluent and high-income clients plan ahead to keep more money in their pockets by using some smart tax savings strategies.
Looking at this Historical Tax Rate Chart 1913 - 2019, the current top income rate is relatively low. Similar to the importance of diversification in investing, I think the thought of tax diversification is relevant as we help people plan for their financial future. I want to share five tax savings strategies here with some examples:
- Diversify Your Taxable Income. Investors should consider owning investments in all three tax buckets: tax-deferred (such as 401(k), IRA), tax-free (Roth IRA, HSA) and taxable (individual, joint, revocable living trust). The tax treatments are different in each of the three buckets before withdrawal: you can sell investments with gains or losses inside the tax-deferred bucket and tax-free bucket without reporting them to IRS; you must watch for short-term or long-term capital gains, interest income or dividend income each year inside the taxable bucket.
When it’s time to withdraw, you’ll pay the ordinary tax rate (normally higher than long-term capital gain rate) on the distributions from the tax-deferred bucket. You won’t need to pay any taxes on distributions from your Roth IRA after age 59.5 or having met the five-year rule after converting some IRA money to Roth IRA. You use after-tax dollars to fund a Roth IRA, but any distributions including earnings after age 59.5 will be tax-free. IRS determines the income limit each year for making contributions to a Roth IRA.
Since you cannot predict your future income tax rates, owning investments in all three tax buckets allows you to have the maximum tax planning flexibility during retirement in order to reduce taxes. For example, if our government’s deficit continues to be large, and during your retirement the tax rates may go up for people earning over $200,000 annual taxable income, you may be able to withdraw some money from your Roth IRA instead of IRA to keep your taxable income below $200,000, therefore paying taxes at a lower rate. When tax rates go down because of the change of the president or congress, then you can switch to withdrawing from your IRA and taxable account.