How to Save Taxes…By Paying More Now?

By James Moore, CFP®

During tax season a few years ago, we had a client reach out to us with a question. This client was comparing tax returns with a friend. The friend had asked our client, “Why did you make a Roth IRA contribution? You don’t get a deduction for that. You should undo that contribution and put the money into a Traditional IRA instead. You’ll save lots in taxes!”

Tax Planning is More Than Maximizing Deductions

It was a good opportunity for us to revisit the tax strategy we had in place with our client.  He was young, and his income put him in a low tax bracket for the year. Based on some reasonable assumptions, it was likely that his income would increase significantly over time as he progressed in his career, which would put him in a higher tax bracket in the future.

Because of that, it was better to forego the deduction now and recognize the income while he was in a low tax bracket, which he might not be in again for a long time. Getting money into a Roth IRA, to grow tax-free and not taxed upon eventual withdrawal, would save this client taxes over the long-term.

So while this client’s friend was technically correct that a Traditional IRA contribution would have saved him taxes this year, it was not the ideal long-term strategy for him. Our goal for this client was not to pay the least amount of taxes this year - it was to pay the least amount of taxes over his entire life. Sometimes that means paying less in taxes now, but sometimes that means paying more in taxes now on purpose!

No one likes to pay taxes, and the idea of intentionally recognizing income and purposefully paying more in taxes might seem a little counterintuitive.  However, there are quite a few scenarios where it could actually save you taxes in the long run.

Roth vs Traditional

As stated in the example above, if you make a contribution to a pre-tax retirement account, like a Traditional IRA or 401k, you are able to take a deduction on your current tax return. However, when you eventually withdraw the money from these accounts, the amount will count as taxable income to you.

If you make a contribution to a Roth retirement account, you receive no current tax benefit. However, the money inside the Roth account will grow tax-deferred and any withdrawals you make will generally be completely tax-free.

At a very high level it usually makes sense to contribute to a Roth account if you think your current tax bracket is lower than it will be in the future, when you will eventually withdraw the money. However, if you are currently in a high tax bracket and you think your tax bracket will be lower when you will eventually withdraw the money, then it usually makes sense to contribute to a pre-tax retirement account so you can use the deduction now.

New Retirees

If you have just retired or are planning to retire soon, you may have a significant tax planning opportunity. As an example of what this might look like, let’s consider a couple who both decide to retire at age 67. Let’s assume this couple has been saving diligently for decades, and their substantial retirement savings includes a 401k account (which they rolled over into a Traditional IRA) as well as a brokerage account in the name of their trust.

This couple will soon need to start taking withdrawals from their various accounts in order to provide income for their retirement. Compared to their working years, in retirement they now have a greater amount of control over when they recognize income for tax purposes. If they wanted to, they could really limit their taxable income by only withdrawing money out of the brokerage trust account for the first few years. Withdrawals from this account would not count as taxable income to them (their only tax liability would be capital gains and dividends inside the trust account). If they decided to use this withdrawal strategy at the start of their retirement, they could have a few years with some very small tax bills!

However, having a few years with small tax bills would not be the most optimal strategy for this couple. While they could delay taking withdrawals from the Traditional IRA for a while, Required Minimum Distributions (RMDs) will begin for them at age 73, at which point they would have to start recognizing significant taxable distributions. These taxable withdrawals would push them into a higher tax bracket. Because of their sizable IRA, these taxable withdrawals will continue for the rest of their lives, which means that they will likely never be in a low tax bracket again.

Instead, a better strategy for this couple would be to take advantage of those first few years of retirement before the RMDs start at age 73. Even though they aren’t required to, they should start taking money out of the Traditional IRA while they are still in the lower tax brackets. And, instead of just simply withdrawing funds from the Traditional IRA, they could instead do Roth conversions with some of the funds. A Roth conversion is essentially a way to convert taxable money (Traditional IRA) into an account that will never be taxed again (Roth IRA).

By being strategic in their early years of retirement, this couple could save a lot in taxes and set themselves up well for the future.

Capital Gain Harvesting

You may already be familiar with the idea of tax loss harvesting—intentionally selling investments that have gone down in value inside a non-qualified account so you can recognize a capital loss and claim a deduction on your tax return. It’s a helpful strategy and is a nice way to get something positive out of a bad investment or bad market environment.

But there is also a more counterintuitive counterpart to this strategy called capital gain harvesting—intentionally selling an investment that has gone up in value with the purpose of recognizing that gain on your taxes that year. You are able to harvest gains even on investments you want to keep. There is no wash sale rule like there is for tax loss harvesting, so you could sell an investment and immediately buy it back if you wanted to. This way, you can keep the same investment, but it will now have a reset cost basis, which means less of a future tax liability.

Generally, deferring gains and taking losses makes the most sense if you are in a higher tax bracket. However, if you ever find yourself in a year where your income is a little lower than normal, it could be a great time to look at doing some capital gain harvesting. It’s important to note that long-term capital gains and qualified dividends have completely different tax brackets compared to ordinary income. Because these brackets have a broader range and the rates are more favorable, it could be possible for you to pay a low tax on capital gains even if you have a decent amount of other income that year. You might even be able to recognize some gains at a 0% federal tax rate.

A Few Cautions

Intentionally recognizing income can be very beneficial, but it also requires careful planning. The tax code is complicated and you need to fully understand the impact additional income might have on your situation. Are you receiving Social Security? A different percentage of your benefit will be taxable depending on your income level. If Social Security provides the majority of your income, recognizing additional gains could potentially cause your benefit to go from 0% taxable to as much as 85% taxable.

Are you on Medicare? Your premiums are affected by your Modified Adjusted Gross Income amount. It’s important to be aware of the applicable thresholds and that you consider any potential premium increases in your calculations and planning.

One final caution—whenever you do something for tax purposes, first consider your overall goals. Tax savings should not take precedence over wise investment decisions.

Don’t Wait!

If you miss a year of recognizing income in a lower bracket, that opportunity is gone forever! If you want to do a Roth conversion or realize capital gains in a taxable account, you have to do it by December 31st of that year. This is why proactive tax planning is important.

Your financial situation is unique, and the best way to approach tax planning will be unique for you. If you have any questions, schedule a complimentary phone call or meeting with one of our fee-only financial advisors.