Tax-Efficient Investing for High Earners
When it comes to taxes, it’s often the largest expense for many of us. Tax-efficient investing is important because the more income you earn, the higher your current income tax rate will be. Therefore, to reduce the expense of taxes levied, it’s important to make sure your planning includes tax efficient investing strategies.
Here are a few tax-efficient investing strategies for high earners.
Contributing to Tax-Advantaged Accounts
To help reduce your current and future taxes, contribute to tax-advantaged accounts.
- Tax-deferred accounts such as a Traditional IRA and Traditional 401(k) plans, allow you to contribute pre-tax dollars. You might be able to deduct these contributions, reducing your taxable income. With these accounts, you’ll pay taxes once you withdraw funds in retirement.
- Tax-free accounts like Roth IRAs and Roth 401(k) plans, allow you to fund the account with after-tax dollars. This allows your investment to grow tax-free, and qualified withdrawals in retirement are also tax-free. Roth IRAs set income limits of $140,000 for individuals or $208,000 or more for couples.
- Backdoor Roth IRA – If you earn too much to contribute to a Roth IRA, a Backdoor Roth IRA is a legal way to maneuver these income limits by converting a Traditional IRA to a Roth IRA.
- Contribute up to $6,000 (or $7,000 if you’re age 50 or older) to a Traditional IRA.
- Once the money is in the Traditional IRA, convert that IRA into a Roth IRA.
Remember, only post-tax dollars can go into Roth IRAs, so you’ll want to have enough liquid money to pay taxes on the conversion and any gains from the Traditional IRA. In addition, you might incur higher taxes when establishing your backdoor Roth IRA, but can save more in the future.
Tax-Efficient Investing Decisions
Some investments can come with tax benefits. Generally, income you earn from municipal bonds is tax-free at the federal level, and depending on the state, may be tax-free at the state and local levels too. In addition, consider accounts like a tax-managed mutual fund – where the owners actively look for tax-efficiency. Also, consider tax efficient index funds and exchange-traded funds which passively track long-term investments in a target index. It’s important to check with your Financial Advisor to be sure your investments are matching your tax goals.
Matching Investments with the Right Account Type
If you place your investments in the right account type, you’ll be able to receive potential tax benefits without increasing how much you’re liable for with taxes.
Figuring out where to place your asset can depend on the financial profile, tax laws, investment holding period, and return properties of underlying securities.
- Investments which produce taxable income, like stock funds or taxable bonds, may be better in tax-deferred accounts.
- Tax-neutral investments, like municipal bonds or tax-managed mutual funds, don’t typically generate high taxes. Because of this, you may not need to put them in non-tax-deferred account that could restrict your access to these funds.
It’s a good idea to be sure where you’re holding different investments aligns with your overall financial strategy.
Diversifying your Taxes
Maintaining different types of accounts can help minimize the tax burden in retirement. Here are the ways different account types are taxed:
- Roth IRAs can grow tax-free if the owner meets certain requirements for qualified distributions; state taxes may apply.
- Traditional IRAs offer the ability to grow tax-deferred.
- Brokerage accounts may have taxable growth.
Triple Tax Benefits of an HSA
A Health Savings Account (HSA) can help pay for eligible medical expenses with pre-tax dollars, and comes with three main tax benefits:
- Your contributions are 100% tax-deductible, allowing you to deduct from your gross income.
- All the interest you earn is 100% tax-deferred, so funds will grow without being subject to taxes if used for eligible expenses.
- Any withdrawals are 100% tax-free if used for eligible medical expenses, such as deductibles, copays, prescriptions, vision, and dental care. Here is a list of eligible medical expenses via the IRS website.
You can only use an HSA if you have a high-deductible health plan, or if you have existing HSA funds. Medicare is considered a different health plan, so if you’re enrolling in Medicare, you won’t be able to contribute to an HSA. However, you can still use any funds you previously saved in an HSA for medical expenses, with no expiration date or required minimum distributions.
Flexibility with a Non-Retirement Advisory Account
While there are tax advantages with accounts like a 401(k), 403(b), and IRAs, there are some limitations, too. With a non-retirement Advisory account, you’ll receive advice and monitoring anytime for your investments.
Non-Retirement Advisory accounts aim to avoid conflicts of interest, and are required to disclose anything that is not avoidable. When it comes to trading fees, Advisory accounts wrap trading costs in one overall fee. A few advantages of non-retirement Advisory accounts include:
- No required minimum distributions – it’s up to you when you’d like to withdraw funds.
- Many investment types – there are different types of investments available, such as stocks, bonds, exchange-traded funds (EFTs), and mutual funds.
As a strategy, tax-loss harvesting is selling an investment for a loss, allowing you to offset gains each year and reduce your income tax liability. If the losses from your investments are more than what you gained, you can offset up to $3,000 of earned income yearly. This can help minimize taxes you may owe on capital gains. By selling an investment which lost value, replacing it with a similar asset, and using the investment you sold at a loss, can help offset realized gains. Remember, you’re only able to use this strategy with taxable investment accounts. Retirement accounts that grow tax-deferred are not subject to capital gains tax.
Working with a Professional
While there are many tax-efficient investing strategies, your finances are unique to you. Which is why it’s important to work with someone who understands and can help identify the right investing tactics for your goals. As a high-income earner, it’s valuable to work with a professional, well-versed in strategies to help you pursue your goals. In addition to financial guidance, your advisor should be someone who can clearly communicate with you and help you make wise decisions. The reward of working with a quality advisor is worth it! As always, we’re here to help – please contact us if you have any questions, or if we can help you in any way!
Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against a loss. This material is intended for informational purposes only, and should only be relied upon when coordinated with specific individualized professional advice, as individual situations will vary.
In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. An issuer may default on payment of the principal or interest of a bond. Bonds are also subject to other types of risks such as call, credit, liquidity, interest rate, and general market risks. Municipal bonds are federally tax-free but other state and local taxes may apply. If sold prior to maturity, capital gains tax could apply.
IRA withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax. Roth IRA withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Neither LPL Financial, nor its registered representatives, offer tax or legal advice. Always consult a qualified tax advisor. Always consult a qualified tax advisor for information as to how taxes may affect your particular situation.