Tax Planning

Tax Planning

Five Tax Saving Strategies for the Affluent

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:

  1. 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.

Must-Know Facts About Health Savings Account

By Echo Huang, CFA, CFP®, CPA

A Health Savings Account (HSA) can be a powerful tool to help you save and invest, now, to pay for your qualified medical expenses (QMEs) during retirement.  The HSA has become popular as more and more employers move to high deductible health plans (HDHP) in order to reduce insurance premiums.  Employees must choose the HDHPs instead of traditional health insurance plans if they want to use their HSAs to fill the gap.  I have used HSAs personally for about 10 years and I want to share these essential facts with you:

  1. The HSA provides triple tax benefits.  Contributions are made with pre-tax dollars (free of federal, state and FICA taxes) through payroll if your employer offers it.  If you purchase an HDHP on your own in the insurance market, you can set up your own HSA online and make contributions before the tax return filing deadline.  You can choose to invest the balance and the growth is tax-deferred.  Distributions are income-tax free if you use them to pay for qualified medical expenses (QME).  "Typical" retiree expenses on health care are often as high as $500/month (or $1,000/month for a married couple), much of which are HSA-eligible QMEs, including Medicare premiums and out-of-pocket medical costs (although Medigap coverage doesn't count). 
     
  2. How much can I contribute per year?  For a self-only HDHP, you can contribute up to $3,400 in 2018 ($3,500 in 2019).  For a family HDHP, you can contribute up to $6,900 in 2018 ($7,000 in 2019).  If you are age 55 and older, you can contribute additional $1,000.  
     
  3. The HSA balance does not expire, unlike the Flexible Spending Account (FSA).  You don't have to spend the balance within the calendar year.  You can keep the receipts of QMEs and get reimbursed from your HSAs many years from now as long as the expenses have not been reported as medical expenses on tax returns and increased your total itemized deductions.  If your income is not low, it is difficult to get tax benefits through reporting medical expenses on Schedule A because total QMEs for the calendar year must exceed 7.5% of adjusted gross income (AGI) to generate tax benefits.  Beginning in January 1, 2019, the 7.5% of AGI will increase to 10% of AGI.  If your AGI is $100,000, you must incur greater than $10,000 QMEs in one year to be worth it to report them on Schedule A.  Therefore, if you don't get tax benefits from your tax returns, then you can save the receipts and file them in a folder called "To Be Reimbursed from My HSA" - you decide the timing of distributions in the future.

Withdrawal Strategies During Retirement

By Echo Huang, CFA, CFP®, CPA

You may have heard of the 4% rule for withdrawals during retirement as you approach your retirement. I would like to clarify this rule in this blog post and offer some thoughts on how to withdraw from your nest egg to make the money last for at least your lifetime.

What is the 4% rule?

The rule states that if you begin by withdrawing 4% of your nest egg's value during your first year of retirement, and then adjust subsequent withdrawals for inflation, you'll avoid running out of money for 30 years. If you retire with $2 million, the first year's withdrawal is $80,000 and if the inflation is 2% the second year, you adjust the second year's withdrawal by 2%, that is $81,600. It's simple to use and has been considered as the standard rule for withdrawals for many years. In my opinion, this rule is far from perfect for several reasons:

  1. This rule assumes that your investment mix is 60% stocks and 40% bonds. If you're conservative and allocate 75% to bonds, your portfolio may not grow enough to last your lifetime. If you are more aggressive and have 80% in stocks, your portfolio value may decline sharply during stock market crashes and won't have enough time to recover. Your investment mix should be designed based on all your factors: risk preference, loss capacity, time horizon and market conditions.
  2. The time frame of 30 years of retirement may not be long enough for some people and may be too long for others. If you retire early at age 50, your portfolio may have to last more than 30 years. If you retire late at age 70, you may limit your lifestyle spending too much by sticking to the 4% rule if you don't expect to live past age 85 based on your health conditions and family history. There is no do-over in retirement - running out of money even a year before you die is a failure and you simply cannot go back to work at age 89.
  3. Investment return expectations are outdated. When the rule was introduced in the early 1990s by William Bengen, then a financial planner in California, the historical data used at the time included periods that bonds had a high rate of return. Based on the current and projected interest environment, it is unreasonable to assume bond returns of 5% to 6% for next decade. The current federal funds rate is 2.25%. The federal funds rate's year-end estimate for year 2020 is 3.38%, based on the September 2018 FOMC meeting.

Savings Alone Won't Pay for College

By Echo Huang, CPA, CFP®, CFA

A college diploma opens the door to a lifetime of higher earnings. Based on Bureau of Labor Statistics, in 2016 dollars, Bachelor's degree holders earn nearly $1 million more over a lifetime than those who have only a high school diploma. Those with professional degrees earn over $2 million more. In addition, college graduates enjoy much better job security and opportunity, especially during economic downturns. Based on "The State of Entry-Level Employment in the U.S. March 2017" by The Rockefeller Foundation, seven in ten U.S. employers look for college degrees when hiring entry-level workers.

For many parents, college is one of life's most important, and expensive, investment goals. How much does it cost? How much can you expect from financial aid? How can you invest and earn more while borrowing less? I would like to answer these questions here and provide some strategies for successful investing.

Have You Considered This Mega Roth Strategy?

By Echo Huang, CPA, CFP®, CFA

Last month, one of my new clients and I called the administrator of her old 401(k) plan to rollover the balance to her IRA account at TD Ameritrade.  To her surprise, she had $36,000 in after-tax contributions (not the same as a Roth) with earnings of $70,000 from the after-tax contributions she made many years ago in addition to $700,000 pre-tax contributions and earnings.  She was able to request two checks - one for the $36,000 to a new Roth IRA account (a Roth conversion that is tax-free because there is no taxation on otherwise after-tax funds!) and one for the $770,000 to a traditional IRA account (which does not incur an income tax assessment by virtue of being a rollover).  The end result – now she has $770,000 of all pre-tax funds in an IRA, $36,000 in a Roth IRA, and her tax cost this year is zero!

One great benefit is that the balance in her Roth IRA account will now grow tax free!  It was a pleasant surprise for both her and for me, but I thought to myself “If she had rolled-over the $36,000 to her Roth IRA earlier in 2014 or 2015, the earnings from this after-tax contribution in the past two to three years (i.e. $7,000) would have been tax-free instead of being in an IRA that will be taxable upon distribution.”  And this made me want to tell you, that if you have made any after-tax contributions to your 401(k) from before the Roth 401(k) became available, you should consider reviewing the plan provisions on in-service withdrawals if you still work for this company.  If you have already left or retired from this company, it’s still easy, you can do what my client did.  But leaving an after-tax balance in the plan does not help you grow tax-free because the earnings from the after-tax contributions are taxable if you take distributions from the plan to spend in the future.

Are Investment Advisory Fees Tax Deductible?

It’s tax season again, and a question we get from a number of clients after receiving their year end statements is, “Are my investment advisory fees tax deductible?” And the answer is an equivocal, “It depends.”

Congress did grant a tax deduction for certain investment expenses, but with anything to do with the tax code, the devil’s is in the details. Not to worry though, we’ll use this opportunity to settle the issue no matter your situation.

Why Would I Want to Defer Compensation?

By Steve Drost and Echo Huang, CPA, CFP® and CFA

An old proverb states “A bird in the hand is worth two in the bush” suggesting one should be content with what they have (or will have shortly) rather than roll the dice on the unknown.  One who wholeheartedly believes in this proverb may react swiftly and decline to enroll in their employer-offered deferred compensation plan.  This could be perceived as a rational decision; why would you want to receive a portion of your salary or bonus in 5+ years when you can receive it now?   What benefits could there be to electing to give up your bird, or compensation, and “roll the dice” on the unknown?

Currently regulated by Section 409(A) of the Internal Revenue Code (IRC), nonqualified deferred compensation (NQDC) plans allow employees to move earned income from one year to future years, thus allowing for income tax and cash flow planning opportunities.  This is different from deferred compensation in the form of elective deferrals to qualified plans (such as a 401(k) plan) or to a 403(b) or 457(b) plan.  By moving earned income to future years, you can reduce the current year’s taxable earnings which can be extremely beneficial during high earning years.  In the example below, assume a single person expects to earn a salary of $200,000 and receive a bonus of $100,000 in 2017 and then retire in 2018.  Let’s assume he has expected portfolio interest income of $50,000 (starting in 2017 and continuing) and will receive $20,000 per year from social security during retirement.  Lastly, to make the comparison simple, assume all figures below are in “taxable income” before applying the tax rates by ignoring the deductions and personal exemptions. In Figure 1 you will find this individual’s total income, total taxes due, effective tax rate, and then the amount of money taxed at their marginal tax bracket for 2017. Column 2 displays the outputs assuming he did not elect to defer any compensation.  Note that his effective tax rate is over 28% and that $158,349 (which is mainly comprised of his bonus) is taxed at 33%.  Now suppose he defers his bonus to 2022; he elects not to receive the funds in 2017 but rather receive the payment in 2022.  Notice the significant drops in both the individual’s effective tax rate and the portion of income taxed at his highest bracket, the 33%.

Health Savings Accounts (HSAs)

By Echo Huang, CPA, CFP, CFA

The deadline for 2017 benefits enrollment is approaching quickly for many employees.  More and more employers have started to offer high-deductible health insurance plans in addition to the traditional HMO or PPO plans.  You can set up health savings accounts (HSAs) only if you choose one of the high-deductible health insurance plans instead of the traditional HMO or PPO health insurance plans with co-pays.  What do you need to know about HSAs in order to make a wise decision for yourself and your family?

Saving for College

By Tyler Lodahl and Echo Huang, CPA, CFP and CFA

As the former President of South Africa and Nobel Peace Prize recipient, Nelson Mandela, once said: "Education is the most powerful weapon which you can use to change the world." And even while obtaining an education is integral to our world, planning for a child’s education can be an exciting, yet daunting task. Thankfully there are some tax-advantaged strategies you can consider:

1.       Qualified Tuition Programs/529 plans

2.      Coverdell ESA (Education Savings Account)

3.      Roth IRA

4.      American Opportunity Tax Credit (AOTC) and Lifetime Learning Credit

What is a 529 plan and what are the benefits of utilizing one?

 A 529 plan is a tax-advantaged savings plan designed to encourage savings for future college or other post-secondary education expenses.  529 plans, legally known as “qualified tuition plans”, are sponsored by states, state agencies, or educational institutions and are authorized by Section 529 of the Internal Revenue Code. A major benefit of 529 plans is that anyone is able to make contributions regardless of their annual earnings.

To Rollover or Not Rollover Your 401(k) - It Depends

One of the biggest decisions many of our clients face is what to do with their 401(k) plan when they leave their employer. There is no clear cut answer as to whether you should roll over your 401(k) plan to an IRA, another employer’s 401(k) plan, or simply to leave it where it is, because it involves several different factors, including long term investment costs and the availability of investment options within the plans. Both can impact the long term performance of your retirement plan. However, the most critical factor that can have a big impact, both short and long term, are the tax implications of a rollover.  Understanding these implications is essential before making any decision regarding your 401(k) plan.

Here are some of the more common tax complications that arise from a rollover:

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