Tips to Help Minimize Your Tax Exposure
If you read our articles regularly, you’re likely aware of the importance of having a comprehensive financial plan in place to guide your decision-making and help you accomplish your goals. An important component of any Creative Planning financial plan is the implementation of strategies to minimize your tax exposure.
Taxes impact every aspect of your financial life, from the amount you receive as a paycheck or how much you pay in sales tax each time you make a purchase to the amount you’re able to pass along to your loved ones after you die. Taxes can be a big headwind to wealth accumulation and preservation. If you’re not taking steps to minimize your taxes, your investment returns could suffer and you could be missing out on significant financial planning opportunities.
If it’s been a while since you’ve evaluated your approach to minimizing taxes, now may be a great time. The following tax planning strategies can help you get started.
#1 – Understand how your income impacts your tax exposure.
Before implementing a tax planning strategy, it’s important to have an understanding of how U.S. federal taxes work. As a refresher, the United States uses a progressive tax system, which means the percentage of income taxed increases as an individual’s income grows, as indicated in the following table.
One of the most effective ways to lower your tax liabilities is by finding ways to lower your taxable income, especially if you experience a particularly high-income year. Strategies for lowering your taxable income include:
- Making contributions to tax-deferred retirement accounts
- Donating to charity
- Implementing a strategic retirement withdrawal strategy to minimize tax exposure
Your wealth manager and tax advisor can help you determine what combination of strategies make sense based on your personal financial situation and future goals.
#2 – Improve the tax-efficiency of your investment portfolio.
In addition to income tax, you may be subject to taxes on your investment gains. That’s why it’s important to take steps to improve the tax efficiency of your investment portfolio. Your wealth manager can help you implement a variety of tax-efficient portfolio management strategies, including:
- Asset location – Asset location refers to the strategy of dividing assets among taxable and non-taxable accounts according to each asset’s tax characteristics. Essentially, asset location allocates tax-efficient investments to taxable accounts and tax-inefficient investments to tax-advantaged accounts. When implemented correctly, this strategy can help minimize portfolio taxes and enhance returns.
Because stocks receive favorable capital gains tax treatment, it’s wise to place these investments in taxable accounts or Roth IRAs. If these assets are passed on to your heirs following your death, your heirs may be eligible for a step-up in cost basis, effectively resulting in zero taxation. Investments with lower return potential and unfavorable income tax treatment, such as U.S. government bonds and cash, should be placed in tax-advantaged accounts (such as traditional IRAs) to reduce their current tax exposure.
Beware of advisors that use models for your investment account. This is often an indicator that there’s no asset allocation strategy in place to minimize taxes on investment returns.
- Tax-loss harvesting – Within an investment portfolio, investors are only taxed on net capital gains, which equals gains minus losses. This means any realized losses can be used to reduce your tax liability. Tax-loss harvesting is the process of looking for opportunities to realize losses in order to offset gains.
Tax-loss harvesting works by selling an investment that has declined in value in the short term, a common occurrence in a heavily weighted equity portfolio, and replacing the investment with a highly correlated alternative. If done correctly, your risk profile and rate of return remain unchanged, but the temporary tax losses are extracted in the transaction.
By realizing the investment loss, a tax deduction is generated that can lower your taxes. You can then reinvest your tax savings to further grow the value of your portfolio.
Tax-loss harvesting should be done throughout the year — it’s not something to look at only in December. If you’re waiting until the end the year, you’re probably missing a lot of tax benefits. This is really an ongoing process that should be part of day-to-day investment management.
#3 – Diversify your retirement savings.
An important strategy for lowering your taxable income in retirement is to save in a variety of retirement accounts with different tax treatments. Doing so can help you lower your taxable income today while also reducing your tax exposure in retirement.
Different types of savings vehicles are taxed in the following ways:
- Tax-deferred accounts – When you contribute to a tax-deferred account, such as a traditional IRA or 401k, you do so with pre-tax funds, lowering your taxable income during the year in which the contribution is made. You’ll later be taxed on these assets as ordinary income when you withdraw them in retirement.
- Taxable accounts –Assets held in bank accounts and nonqualified investment accounts are continually subject to taxes at either ordinary income or capital gains tax rates.
- Tax-exempt accounts –Assets contributed to tax-exempt accounts, such as Roth IRAs and 401ks, are made with after-tax funds, which means they don’t reduce your taxable income during the year in which they’re made. The benefit is that qualified distributions can be withdrawn tax-free in retirement.
When you save in a variety of account types, you have the flexibility to customize your retirement withdrawal strategy as your tax planning needs evolve over time, which can help lower your tax exposure as your situation changes from year to year.
I see it over and over again where a client has been a diligent saver their entire life and is entering retirement with just a tax-deferred account. Although there are still planning strategies to minimize taxes throughout your retirement years, there are many planning opportunities that should be considered before retirement.
#4 – Maximize your charitable impact.
During years in which you itemize your taxes, you can take a tax deduction for charitable donations. Giving cash is a great way to support the charitable causes that are important to you, but you may be able to increase both your tax savings and your charitable impact by making an in-kind donation of appreciated securities, such as stocks, bonds or mutual funds.
When you make a direct transfer of appreciated securities to a charitable organization, you avoid triggering a taxable asset sale. Because charitable organizations are tax-exempt, the charity could then sell the security without paying taxes on the transaction. As a result, you can claim the full market value as a tax deduction, and the charity can receive a larger donation than if you had sold the security, paid taxes and donated the remainder.
If you don’t typically file an itemized tax return but still wish to claim a charitable deduction, it may make sense to combine two or three years’ worth of charitable donations into a single tax year. This strategy is referred to as “bunching.”
The bunching technique can benefit donors whose itemized deductions fall below the standard deduction ($29,200 for married filing jointly or $14,600 for single filers in 2024). In a tax year during which combined gifts are made using the bunching strategy, you can use a charitable vehicle, such as a donor-advised fund (DAF), to receive an immediate tax deduction through itemizing federal deductions. In subsequent years, you can then issue grants from the DAF to qualified charities using the standard deduction.
Could you use help implementing strategic tax planning strategies within your portfolio? Creative Planning is here for you. Our teams have experience navigating a wide range of tax and financial challenges, always with the goal of helping clients achieve their long-term goals. For help with your tax planning strategy, or with any other financial matter, please schedule a call.
