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Five Tax Saving Strategies for the Affluent

January 29, 2019

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.

These are the rules that make Roth IRAs special: 

a. You can make contributions at any age;

b. You are not required to make a “required minimum distribution (RMD)” from a Roth IRA.  (Traditional IRA account owners must start taking distributions at age 70.5);

c. A non-working spouse can open a Roth IRA based on the working spouse’s earnings if they file tax returns jointly;

d. You can still make your annual contributions if you convert money from a traditional IRA to a Roth IRA in the same year.  

e. You can contribute to a Roth IRA even if you participate in a retirement plan through your employer.  

Can I qualify to contribute to a Roth IRA based on my income?  If you are single, you must have a modified adjusted gross income (MAGI) under $135,000 to contribute to a Roth IRA for the 2018 tax year, but contributions are reduced starting at $120,000. If you are married filing jointly, your MAGI must be less than $199,000, with reductions beginning at $189,000.  For 2019, the numbers are higher. The modified adjusted gross income for singles must be under $137,000; contributions are reduced starting at $122,000. For married filing jointly, the MAGI is less than $203,000, with phase out starting at $193,000. 

How do you start creating these three buckets of money, especially in your 40s and 50s when your earned income is too high to contribute to a Roth IRA?  You can consider “Backdoor Roth IRA”.

Example: My client David is age 50 in 2019 and his MAGI is $300,000 and married filing jointly.  He is planning to maximize contributions to his 401(k) plan at work that is $19,000 plus $6,000 catch-up contributions for people age 50 and over in 2019.  He can still contribute to his traditional IRA account at TD Ameritrade up to $7,000 ($6,000 plus $1,000 catch-up contribution) because he has earned income.  The IRS has income limits to calculate how much of the contributions to an IRA are tax deductible and whether he is covered by a retirement plan at work.  As his MAGI is over $199,000, he cannot deduct any of his contributions to his IRA on tax returns.  However, the non-deductible contributions must be reported on Form 8606 when his federal income tax return is filed so that the IRS has the record of the cost basis of this IRA.  When he decides to convert this IRA balance to a Roth IRA in future years, he only pays income taxes on the earnings portion of this distribution in the year of the Roth conversion.  If he does not have pre-tax dollars in this IRA, the taxes he will pay are minimal and he creates a large Roth IRA over time.  Therefore, do not forget to report contributions on your tax returns. As you convert any IRA balance to a Roth IRA, you’ll receive a tax form 1099-R that shows the distribution amount from your IRA, which must be reported on your tax return Form 1040. 

For the retirees, in a year or a few years in which their income is lower than usual, consider converting a small amount of IRA to Roth IRA each year by watching out not to get into the next tax bracket.  

For example, looking at the 2019 federal tax rates, your next tax rate is 24% at $168,400 taxable income as a married joint filer and your current projected taxable income for this year is about $135,000 (at tax rate of 22%) because you just retired and decided to delay collecting social security benefits until age 70.  Now you can convert an additional $30,000 IRA balance to a Roth IRA by paying taxes at a 22% rate.  This way, you can increase your tax-free bucket without paying a high-income tax rate, which will help you keep taxable income low as you withdraw from your Roth IRA when your social security benefit starts at age 70.  

If you started a new business and have reduced taxable income in the first year or two, it’s a good opportunity to consider converting some of your IRA to a Roth IRA by watching out for your next tax rate.  I’ve converted a significant amount of my IRA balance to a Roth IRA myself twice over the past 16 years to dramatically increase my Roth IRA balance. As you need to pay income taxes on the Roth conversion, it’s important to start saving some money early in a non-retirement account and invest not as aggressively as your Roth IRA so that you can tap into it to pay for taxes on the Roth conversions when the right opportunity presents itself. 

If you are able to save a lot more and have a sizable non-retirement account already, you can also consider switching from contributions to your 401(k) to Roth 401(k) if your employer offers Roth 401(k) as well because the annual maximum is the same, but you essentially have increased your retirement savings by funding it with after-tax dollars and distributions that will be tax free after age 59.5.  Paying taxes now at a certain rate instead of paying taxes later at an uncertain rate is a way to hedge against future income tax increase - through tax diversification.  Use some financial planning tools to project your future tax rates based on your projected taxable income year by year to age 95 and today’s tax laws will help you make smart decisions.  Keep in mind that you can contribute some to the traditional 401(k) plan and some to the Roth 401(k) plan as long as the total does not exceed the IRS maximum per year.  In addition, your employer’s matching contributions will be taxable to you upon distributions.

  1. Help Your Children Fund Their Roth IRAs.  If your children have a part-time job or a summer job, earning any amount of income, you should encourage them to open a Roth IRA now which you can help them fund up to his/her earned income, with a maximum of $5,500 for the year 2018 and $6,000 for the year 2019.  Even if they only make $4,000 per year and may be able to save $2,000 for the Roth IRA, you can help with another $2,000 to encourage starting saving now and investing for their retirement early.  The long-term growth of this tax-free account for their retirement is significant.  You can teach them the magic of compounding over 50 years and they won’t have to pay taxes on distributions even if they are wealthy some day.

For the young people who just start in their career and their income is low enough to be eligible to contribute to a Roth IRA, generally I recommend maximizing Roth IRAs ($6,000 in the year 2019) after they have contributed enough to get all the employer’s matching in their 401(k) plan (don’t leave money on the table).  

  1. Be Creative with Your Charitable Giving. If you have any appreciated stocks in your non-retirement accounts, instead of writing checks to charities or using payroll deductions at work, you can simply set up a donor-advised fund through your financial advisor and transfer the appreciated stocks that you have unrealized long-term gains and deduct the fair market value as charitable deductions on tax returns in the year of funding the donor-advised fund, even though you don’t have to determine the recipients of your generosity until later years.  

For example, if you normally give $5,000 to charities by writing checks, you can donate a total of $100,000 value of appreciated stocks (with a cost basis of $60,000) to your donor-advised fund, and you can save about $40,000 income taxes this year and when you sell the stocks to diversify to other investments inside the account, you don’t have to report the long-term gains of $40,000 on your tax returns, saving you an additional $12,000 in capital gains tax.  If this account grows, you will have more money to help charities and you can decide to choose the amounts and the charities during your lifetime.  You do not take another charitable deduction when the money (grant) goes to charities from this account.  Upon your death, the successors you have named will continue your legacy.  

A charitable remainder trust can avoid capital gains taxes on appreciated assets, allowing you to receive income for life and receive a tax deduction now for a charitable contribution that will be made after your death. A charitable lead trust can avoid taxes on appreciated assets, earn an immediate tax deduction and still provide an inheritance for your heirs later. 

  1. NUA Strategy. NUA means Net Unrealized Appreciation of employer stock inside a retirement plan at work.  Before the Enron crisis, many employers used to match company stock in the 401(k) plan and employees kept the stock for many years.  When you’re about to retire and considering taking distributions from your 401(k), you have the opportunity to decide what to do with the employer stock.  If the cost basis is low (let’s say 20% to 30% of the market value), then you can consider taking the stock out by transferring the shares to a non-retirement brokerage account (not an IRA account).  The tax treatment is that you pay ordinary income tax on the cost basis in the year of taking the stock out of the plan.  The appreciation from the cost basis will be treated as long-term capital gains when you sell the shares anytime in the future inside your non-retirement brokerage account.  The mutual funds inside the 401(k) can be sold and rollover entire balance to an IRA.  The total distributions of the entire 401(k) balance must be completed within the same calendar year.

I just encountered this situation last December when my client’s father passed away suddenly at age 80 and her mother (age 79) inherited a large 401(k) plan balance with about 40% in employer stock and the cost basis was about 20% of market value.  I reviewed the most recent 401(k) statement on December 14th and learned that the RMD for the year 2018 was about $50,000 that needed to be taken out immediately to avoid a 50% tax penalty assessed by IRS.  After I analyzed her other assets, social security income, and pension income to calculate her projected tax rate in the future along with her estimated living expenses, I concluded that taking out this employer stock in-kind and paying income taxes on $75,000 cost basis was the best choice for her because this distribution of stock meets the RMD requirement for the year and she would have over $350,000 worth of stock in an account that she can potentially pay lower long-term capital gain taxes if she sells anytime.  I explained this to her and made a few conference calls with her and the retirement plan and took care of the urgent matter timely to save her $25,000 in penalties and gave her peace of mind. 

Because she also inherited this same employer stock in her other non-retirement brokerage accounts in which she received step-up basis (the cost basis is now the market value on the date of his death), I can help her sell those shares with higher cost basis first to diversify to reduce the single stock risk while keeping the shares (low basis that came out of the 401(k) plan) for much longer.  When she passes away with this low cost basis stock, her children will inherit the stock with step-up basis. 

  1. Maximizing your HSA is the strategy to use tax-free dollars to pay for health care during retirement.  If your employer offers high deductible health insurance plans, you should certainly review this to see if you should choose it to save on monthly premiums and combine with the tax savings from funding your Health Savings Accounts.  You can read the details from my last Blog on this topic to potentially save more taxes now and during retirement.  

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