Tara Thompson Popernik, CFA, CFP, for Valuewalk.com write: Many investors adopt tax-reducing strategies from year to year without taking a step back to look at the big picture. But how you save or spend money today can have a profound impact on your after-tax wealth over the long term and, ultimately, on your legacy.
If you do not invest in a tax-aware manner, federal, state and local taxes may eat up more than half of your investment return. Thus, holistic tax-aware investing is critical at all stages of life. But the control that you can exert over your sources of income will vary over time. Thus, the tax strategies that are most valuable to you are likely to change over time, too.
The Working and Saving Years
During the working and saving years, most people have relatively little control over when to recognize income. If most of your income comes from cash compensation, and that compensation is the only source of the money you spend, you will have few opportunities to control the size of your tax bill.
But you can prioritize saving in ways that lower your tax bill today and for years to come. Saving through a qualified retirement plan allows you to defer today’s taxable income until your retirement years, when you may be in a lower tax bracket. You can also save for your children’s or grandchildren’s educations on a tax-free basis through a college savings plan; give to charity to avoid tax today; and manage your portfolio in a tax-aware manner, as the left column of the Display shows.
The Retirement Years
In retirement, you can also prioritize spending in ways that minimize your overall tax bill, the middle column of the Display shows.
Because you can’t control it, a required minimum distribution (RMD) from an IRA or defined contribution retirement plan is often the first source of an investor’s retirement spending, along with Social Security income. RMDs are taxed at ordinary tax rates.
If you don’t need the entire RMD to support your lifestyle, you may want to consider converting a portion of your IRA to a Roth IRA. This could significantly reduce your annual tax bill going forward and increase your legacy, but you would have to pay some tax upfront.
If you need more than your RMD and Social Security income to support your lifestyle, it is generally most tax-efficient to withdraw additional funds from your taxable portfolio rather than from your retirement portfolio. Funding additional spending from a taxable account allows you to manage the taxable capital gains you recognize. It’s generally a good idea to sell stocks with a high cost basis (lower capital gains) before selling stocks with a low cost basis (higher capital gains). Harvesting losses may help offset some of the gains you recognize.
Sourcing spending dollars in these ways can keep your overall tax bill relatively low and allow your remaining retirement-plan assets to continue to grow on a tax-deferred basis.
Your Legacy
To maximize the assets you leave as a legacy, pay careful attention to the intersection of estate and income taxes. Under current law, each person can leave up to $5.34 million to non-charitable, non-spouse beneficiaries free of federal estate tax. (There is no limit on transfers to charity or spouses who are US citizens.) In addition, most types of assets receive a “step-up” in cost basis at death, erasing any embedded capital gain.
Highly appreciated property that will receive a step-up at death is generally a good candidate for your legacy, and it should generally be among the last sources for spending, so that you can avoid significant tax on capital gains. Certain kinds of appreciated property, like collectibles, are subject to higher tax than the typical long-term capital gain on stocks. Thus, those assets should be the last you sell to fund lifetime spending, as the right column of the Display shows.
There is no step-up in cost basis for retirement accounts, so it’s most efficient to leave a tax-deferred IRA to a charity that will never pay tax (as your taxable beneficiaries would). If you leave a tax-free Roth account to loved ones, they can stretch the nontaxable payments over their expected life spans (although there’s some risk that Congress will limit this benefit).
The intersection of the estate and income tax regimes requires a thoughtful and nimble approach. The rules may change over time. These are matters to discuss carefully with your tax advisors. Bernstein may be able to help you and your tax advisors quantify the benefits and risks of the various strategies you consider.
