As humans, it’s in our DNA to crave action in moments of uncertainty. It’s the fight or flight instinct. Because of this, successful investing will always be counterintuitive to many and difficult for most. When it comes to long-term investing, the data and research continue to support an approach that rewards patience and discipline, not action or reaction. Fortunately, not all aspects of managing your wealth require you to resist against our ancient wiring. In fact, when it comes to tax planning, opportunities abound, in all phases of life, to grab the bull by the horns and to act.
Below we’ve provided actionable items for all three phases of your financial life – working, at retirement and in retirement. But, before we get into the three phases, there are a few things you can and should be doing regardless of what phase of financial life you’re in.
The first is making sure your portfolio is set up as tax-efficiently as possible. We’ve gone into detail here, but the three strategies include: 1) Vehicle selection (Mutual Fund vs. ETF), 2) Minimizing turnover and 3) Asset Location (e.g., 401k vs. Taxable Brokerage Account).
The second action you should be taking on a yearly basis is reviewing your portfolio for tax-loss harvesting (TLH) opportunities. TLH is the process of selling a security at a loss and replacing it with a security of similar characteristics. By capturing, or "harvesting," a loss you can deduct up to $3,000 against your ordinary income and roll the remaining losses forward to use in the future.
Now, let’s assume your portfolio is set up properly and every year-end you review your portfolio to ensure the latest crop of losers has been harvested. What else can be done? We’ll start by revealing the actions you can take to reduce your tax bill while you are still working.
Phase 1 – Working Life
The obvious first step is to make sure you’re maximizing your tax-deferred saving opportunities provided through your workplace 401k plan. For 2016, the maximum amount you can defer is $18,000 ($24,000 if older than 50).
If your cash flow can support it, the next step is to take advantage of a yearly IRA contribution. In 2016, the annual limit is $5,500 ($6,500 if you are older than 50). Many people are surprised to hear they can still make IRA contributions as high earners. Here’s the catch – depending on your income level, your IRA contributions may be deductible or non-deductible. If you’re able to make a deductible contribution, then great, you’ve reduced your income by $5,500. But what if your income is too high and making a contribution won’t reduce your tax bill this year? There might be an opportunity for what’s call a Backdoor Roth IRA.
Backdoor Roth IRA
While the name is suspicious, the strategy is legal and quite effective if used right.
- There are income limitations that restrict high-income earners from contributing directly to Roth IRAs
- Anyone can make a standard IRA contribution, but income rules limit who gets to deduct the contribution amount from their tax return
- There are no income limitations when converting Traditional IRAs to Roth IRAs
A Backdoor Roth IRA exploits a loophole that allows for high earners to build their after-tax assets by converting Non-Deductible IRA contributions into Roth IRAs. Unfortunately, because we’re dealing with the tax code, it’s not quite this simple. When converting IRA assets to Roth, you don’t pay any taxes on the portion of funds you’ve already paid taxes on (i.e., non-deductible contributions), but you do have pay taxes on IRA assets that haven't been taxed yet.
For this reason, the ideal candidate for a Backdoor Roth IRA is a high-income earner with no other IRA assets. If you happen to have a sizable Rollover IRA from a previous 401(k), then the Backdoor Roth IRA loses its appeal because you will be paying higher rates on a large portion of the conversion and the primary objective of any Roth decision is to fund the Roth vehicle at lower marginal rates than the funds will be taxed during RMD distributions.
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