Written by: Jared Defore, CFP®, CPA/PFS
“There are only two things certain in life: death and taxes.” - Benjamin Franklin
Taxes are one of your largest and most consistent expenses you will have throughout your life. I cannot think of anyone who says, “Yeah, I enjoy paying taxes.” So, at Market Street, one of our core focuses is trying to minimize your taxes. With several CPAs on staff, it is part of our DNA.
Tax-Efficient Portfolio Strategies
We try to minimize taxes in many ways. Building our clients’ portfolios is the starting point. Our long-term investment philosophy is built on diversification and tax efficiency. When building a client’s portfolio, the first thing we look at is what types of accounts they have (IRA, Roth IRA, 401k, 403b, brokerage, etc.). Each of these accounts are taxed differently, which provides tax saving opportunities.
Next, we place our investments in the accounts forementioned based on the characteristics of the investment. Some investments throw off income annually, some grow by price appreciation, and some do a combination of both. Where you place each different kind of investment is crucial to tax efficient investing. Strategically choosing which types of investments to hold in different types of accounts allows us to help clients save on taxes on an annual basis.
Saving on Taxes Based on Your Personal Situation
Now that you have an understanding of one of our core strategies to help clients save on taxes, let’s explore some ways to help clients save money on taxes based on their individual situations. As we are approaching the end of the year, there are several avenues we explore to reduce our clients’ current or future taxes. Below are some of the most popular strategies:
1. Roth Conversions
Roth conversions are most impactful for clients who are retired and have not started taking Social Security benefits and/or have not begun taking required minimum distributions yet. We analyze our clients’ future portfolio needs and compare current tax rates to future tax rates to determine if a Roth conversion makes sense.
If your future tax rate is projected to be higher than your current tax rate, then it may make sense to do a Roth conversion now. Doing so would allow you to pay less tax now than in the future. For example, if your future tax rate will be 22% and your current tax rate is 12%, we may do a Roth conversion now (a taxable event) to pay 12% tax, so you don’t have to pay 22% in the future.
2. Capital Loss Harvesting
I think that the strategy of capital loss harvesting often confuses people when it is brought up. Why would losses be a good thing? First off, losses are not good, but they happen. As part of a diversified portfolio, not everything goes up and down in value at the same time. Because of our long-term investing approach, we at least try to get a tax benefit if an investment experiences a loss. This is most impactful for clients who have a large brokerage account.
By harvesting losses, we can offset gains that have already been taken in the year or the losses can be “banked” to offset future gains. The best part is that when we sell the security, we buy a similar one to replace it so that the client can participate in any future increase in value of that type of investment.
3. Capital Gain Harvesting
Financial planning and tax planning go hand in hand. Understanding a client’s cash flow is important when doing year-end tax planning. For example, if a client has a low income year and we know they will need cash from their portfolio in the following year for a large purchase, we would do some tax analysis to look at generating some capital gains now and see if we could generate that cash and pay 0% in capital gains tax. If we did not know the large purchase was coming up, the cash would not be generated until requested. You could potentially pay 15% or more in tax without even realizing it.
4. Charitable Giving
Towards the end of the year is when a lot of people do the majority of their charitable giving. There are several tax efficient ways to give and we like to explore the best avenue for our clients. For clients who are taking Required Minimum Distributions (RMD), in most cases the most tax efficient way to give is using funds from your RMD. This is uniquely called a Qualified Charitable Distribution (QCD). If you’re not at the point of taking a RMD, the next best option is gifting appreciated securities. Doing this can save you on capital gains tax that you might otherwise would have paid.
These are all great ways to save on taxes, one of your largest and most consistent expenses. If you would like to learn more about these strategies, reach out to one of our team members.