A few weeks ago, a client shared an idea—or phrase, if you will—that stuck with me. Her dad had always told her, “only pay taxes once.” [0:24]
A great father to give tax advice.
Limiting your taxes is a relatively simple idea, yet so many investors struggle to establish accounts in a tax-efficient manner. They end up pay taxes multiple times, often becoming a burden in retirement.
Imagine: you’re gearing up for retirement. You’ve already drafted your two-weeks notice and planned an all-inclusive cruise to the Bahamas as a welcome-to-retirement gift to yourself. But then, you’re blind-sided by a huge tax liability that you (or your financial planner) failed to address early on.
Now, you have to return your Tommy Bahama button-ups and downgrade to a booze-cruise with the college spring-breakers in South Padre Island.
All jokes aside, time is money when it comes to tax planning. Depending on your specific situation, tax-planning strategies can range from relatively simple to complex. We recommend that you talk with your financial advisor to establish a plan.
THE SIMPLE SOLUTION
[1:36] Let’s say you earned $100,000 of income in the year. You paid 24% in taxes and have $76,000 left to invest. You can use a portion of your remaining income to fund a Roth IRA or Roth 401(k). The benefit of a Roth account is you pay income tax before making contributions; thus, once you reach the age of 59½, you are allowed to make tax-free distributions.
In that example, you paid tax once: on the way in.
Another tax-efficient investment vehicle is a Traditional IRA or 401(k). Referring to the previous example, let’s say you earned that same $100,000 salary. However, you chose to defer $19,000 to your retirement account before paying income tax.
Once you retire, the IRS will tax your distributions (principal and earnings). Again, you only paid tax once: on the way out.
THE TRICKY PART: NON-RETIRMENT INVESTMENT ACCOUNTS
[2:54] Retirement accounts are generally tax-efficient—things can get tricky, but we won’t delve into that. Where investors tend to be less efficient is in non-retirement investment accounts.
Here’s an example: you earned $12,000. You paid $2,000 of income tax, leaving you with $10,000 of investable assets.
You put the $10,000 into a dividend-paying mutual fund, which grows to $11,000 in the first year. That’s $1,000 of capital gains and dividend distributions—excellent!
You’ve wanted a dog for a while and found a Great Dane at the local shelter. You’ll name her Great Jane. Great Jane, the Great Dane—clever. So, you withdraw your $1,000 of capital gains and dividend distributions to pay for your new pet ownership expenses. Upon claiming those earnings, you pay additional taxes.
You were taxed twice: once as income tax before investing and again as capital gains tax upon withdrawing.
Owning specific types of investments can make the process even more challenging. For instance, earnings generated from a Real Estate Investment Trust (REIT) are passed to the owner as income tax, not the more favorable capital gains tax.
A POTENTIAL SOLUTION: MUNICIPALS
[5:16] An alternative, tax-efficient investment is a municipal bond or “muni-bond,” as the cool kids say. The interest generated from a muni-bond is generally tax-free at both Federal and state levels, making them a potentially tax-advantaged addition to your non-retirement accounts.
Note: as is valid with any security, investing in muni-bonds depends on your specific situation, the state in which you live, your tax rate, and many other considerations. Talk to a professional.
BEWARE OF ESTATE TAX
[6:07] The estate tax rate and exemption limits can vary tremendously, so it’s essential to stay up-to-date. Currently, there is no estate tax in Colorado; however, one may still be subject to federal estate tax if they exceed the exemption limit of $11.18 million. If you exceed the exemption limit, you may be subject to as much as 40% federal estate tax—the amount varies based on the taxable estate.1
Time for an example: let’s say you accrued $13 million in a non-retirement account over your life. You die (our condolences) and leave your assets to your heirs. Assuming the rates described above, you can pass $11.18 million to your heirs tax-free, leaving $1.82 million exposed to the top-tier 40% federal estate tax. That’s $728,000—a pretty hefty sum.
You’ve been taxed twice: once as income tax before investing your assets and again as estate tax after death. After all, two things are inevitable in life: death and taxes.
That’s a rudimentary example—there are substantially more factors that go into estate planning.
When it comes to estate planning, again, you can get creative regarding tax-efficiency. That can be through numerous means, including trusts or gifting. To learn more about estate planning, join our live-streamed legacy planning webinar on November 12th, 2020 (if you’re reading this after November 12th, 2020, you can find the recorded version on our YouTube page).
DON'T STOP AT A TAX PREPARER
[7:44] Yes, a tax preparer is important. And, as we are not tax professionals, we cannot give tax advice. However, we can offer financial advice, which means looking at your current investment vehicles and long-term objectives, and establishing a tax-efficient financial plan.
A tax preparer will help you minimize taxes in the previous fiscal year. A good financial planner can help you reduce the long-term tax implications of investing.
The last thing I’ll say on the matter is: don’t mess with the IRS. If you decide that you want to dive into tax-efficiency, work with a professional and do things right (legally). There are plenty of get-rich-quick schemes on the world wide web, most of which are hoopla and malarkey.
The higher you climb and grow your net worth, the more important taxation is in your financial plan. Don’t wait to address your tax situation. Only pay taxes once.
1Geler, Ben. “Colorado Estate Tax,” smartasset.com, 10 Jul. 2018, https://smartasset.com/estate-planning/colorado-estate-tax. Accessed 5 Nov. 2020.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
All investing includes risk including the possible loss of principal. No strategy assures success or protects against loss.
Any quoted rate of return is a hypothetical example and is not representative of any specific investment. Your results may vary.
The Roth IRA offers tax deferral on any earnings in the accounts. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may results in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change.
Traditional IRA account holders should consider the tax ramifications, ages, and income restrictions in regard to executing a conversion from a Traditional to a Roth IRA. The converted amount is generally subject to income taxation.
This information is not intended to be a substitute for individualized tax or legal advice. We suggest that you discuss your specific situation with your tax or legal advisor.
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