One of the questions we receive most frequently is, “How can I reduce my taxes?” When asked to elaborate, many prospective clients cannot give more detail; they just know they want to reduce their tax burden. While there are no magical strategies to completely erase taxes, there are strategies we help our clients employ that can add significant value if analyzed and executed properly year after year. Although there are a multitude of different strategies that may be applicable to individuals and small business owners, the three we see add the most value include retirement contributions, Roth conversions, and donor advised funds.
Strategy 1: Retirement Contributions – Thinking Beyond IRAs
The first strategy many people take advantage of, but not to the fullest extent possible, is retirement contributions. Most people know that contributing at least up to the company match, if available, is wise. However, we have many small business owners who came to us with just an IRA, SEP-IRA, or SIMPLE-IRA. Together, we have explored setting up 401(k)s, Individual 401(k)s or Personal Defined Benefit Plans to significantly reduce their tax bill.
We have worked with some business owners who have been able to set aside hundreds of thousands of dollars in retirement plans that are 100% tax-deductible. If we compare that to the $6,000 to $53,000 they were contributing originally, we have been able to decrease their tax burden significantly.
Who is a Personal Defined Benefit Plan Best Suited to?
- Business owners, partners, and key employees
- People with excess cash flow who are willing to save more than $80,000 a year for at least five years
For those individuals who do not want the obligation of funding a plan each year, we have been able to design a 401(k) plan for business owners and their employees to reduce their taxes and contribute up to $53,000 annually. For those who already have a plan setup, we have found ways to save on investment expenses by showing a side-by-side analysis deconstructing all of the fees. Have you reviewed your 401(k) plan and the expenses you are paying?
Looking beyond an IRA or Roth IRA to save taxes is a smart move. Many people are unaware of the potential tax savings available to them and by asking a few questions, we have been able to design a coordinated plan that includes rethinking our clients’ retirement contributions.
Strategy 2: Roth Conversions – Reducing Your Lifetime Taxes
The next strategy we see many people fail to take advantage of is Roth conversions. Most of our clients are going to be in the 25% bracket or higher at retirement due to Social Security benefits, required minimum distributions, and pension income. Typically, the years after retiring, but before age 70 are optimal years to do Roth conversions. For many people, they are in the 15% or 25% bracket during those years and could perform Roth conversions to reduce the taxes they pay over their lifetime. Unfortunately, many people take the view that they want to reduce taxes today and ignore any tax strategies that reduces taxes over a lifetime or even a child’s lifetime.
The starting point with most clients is estimating the current year tax bracket and comparing it to future tax brackets. As a rule of thumb, if someone is in a lower bracket today than in the future, it makes sense to do a Roth conversion. What this means is that we simply move money from an IRA to a Roth and pay ordinary income tax on the amount. If someone can pay tax at a 15% rate compared to a 28% rate, they are effectively lowering their lifetime tax bill. Yes, your tax bill will be larger today, but it will be smaller in the future, making it a net benefit.
By consistently analyzing the projected tax estimate year-to-year, we can target an optimal amount to convert. One of the challenges of this strategy is properly estimating the current year tax rate because the deadline to complete a Roth conversion is the end of the year, whereas retirement contributions can be made until April 15 of the following year. However, once the year is completed, we can always recharacterize all or a portion of the Roth conversion up until October 15 of the following year. Sometimes clients will receive unexpected bonuses that will bump them into a higher bracket, making the Roth conversion less beneficial for reducing taxes.
When do Roth conversions make the most sense?
- High itemized deductions that lower your tax bracket (medical expenses, charitable contributions, etc.)
- Recently retired or starting a new business venture with low income
Roth conversion analysis can be a complicated process, but moving money from an IRA that has required minimum distributions to a Roth, where distributions are tax-free, can be a strategy to reduce taxes over multiple lifetimes. Where we see the most value in Roth conversions is for parents with goals of leaving a legacy to their children, reducing taxes over two lifetimes.
Strategy 3: Charitable Giving – Using Donor Advised Funds to the Fullest Extent
The last strategy, often used in coordination with Roth conversions, is donor advised funds. For clients who are already charitably inclined, we can recommend gifting appreciated securities, real estate, or privately held business interests to a donor advised fund, such as Schwab Charitable (www.schwabcharitable.org).
By donating an asset with significant appreciation, clients can receive a tax deduction in the current year for the value of the gift and avoid paying tax on the appreciation. Clients can then make charitable gifts to the charity of their choosing over time. Often times, we will advise clients to donate five years’ worth of gifting to a donor advised fund for a larger deduction in one year. For example, if a client gives $10,000 a year, we could contribute up to $50,000 of appreciated stock to a donor advised fund, receive a tax deduction for $50,000 and then gift $10,000 a year to charities. We often coordinate this approach with doing a Roth conversion, where we would then also convert $50,000 to a Roth, netting the tax to around zero depending on a client’s individual tax situation.
Another benefit of these accounts is that the funds can be invested and grow over time, giving clients more money to gift over time. For clients who are already charitably inclined and want to see their gifts grow, the donor advised fund is a unique tool to use to reduce taxes in coordination with other planning strategies.
Tax laws are continually changing. Staying on top of the latest rules and the planning surrounding them is a full-time job. We have three CPAs on staff, who help our clients proactively reduce taxes now and in the future. Our aim is to help identify any strategy, no matter how small, that will help our clients reduce their lifetime taxes while achieving their goals.This article was written for information purposes only. It should not be construed as a recommendation to purchase or sell any particular investment product or engage in any particularly investment or tax strategy. You should consult your tax and financial advisors to discuss your individual situation.