Welcome to the second part of the tax smart investing mini-series. I feel like I’m cheating you out of something by calling this as a mini-series as it is really a two-parter. However, I’m a child of the 80s and mini-series is so much more exciting.
Before we begin, I am going to repeat a couple of expressions/mantras/sayings you may have heard me share before. These are specific to taxes. The first is – “It’s not what you make; it’s what you keep.” This simply means I want to know what your returns are after taxes. More importantly, it extends to making sure you are taking advantage of all of the IRS-approved tax savings strategies available to you. Why? Well, the other expression is I do not recommend clients tip Uncle Sam by paying more in taxes than necessary. I will never recommend anything illegal or even unethical. Simply, the IRS provides lots of strategies for saving taxes. It is then up to you as an individual to take advantage of them.
BACKGROUND ON SEI AND MY RESOURCES
I’m going to begin with a bit of background. I utilize a third-party money manager to help me execute tax-smart investing strategies for my clients. There are a few reasons why. They include their years of experience doing this, their low cost, having a dedicated team of full-time, investment-only staff of over 100 professionals, and finally, because they handle billions of dollars.
The company itself is SEI. They are a publicly traded investment management company out of Oaks, PA, which is near Philadelphia. As I mentioned, they handle billions in assets and have been doing this for decades. Their tax-management strategies are the best I’ve come across over my years in the business. Plus, they can do it more effectively than I can and at a comparable price point.
One final comment before we jump into this post. In the previous one we covered 7 specific strategies to be a Tax Smart Investor. Does that mean you are tax smarter? I’ll let you figure that one out. My comment is you may want to check out that post if you skipped over it.
FIVE TAX-SMART PLANNING IDEAS FOR 2021
Once again, these ideas come directly from SEI and their tax planning team. Let’s get right to them, but one reminder of be sure to consult your tax advisor on these ideas.
The Roth Conversion is a common financial planning technique in my world. The problem this idea is attempting to solve and/or mitigate is tax rates will be going up in the future. Please note I said they are and not they may. This is simply based on current income tax rules. The short version is when the tax act went into place a few years back, the tax brackets for corporations were made permanent. However, they brackets for individuals were only temporarily reduced. As I write this those rates will start going up in a few years.
Enough background. Roth Conversion is simply converting a traditional IRA to a Roth IRA. This conversion/action does create a taxable event right now. However, it may be worth doing that for a few reasons.
First, by converting now you are taking advantage of lower tax rates. It also sets the groundwork for you to take distributions in the future that are not subject to potentially higher rates.
Also, if you are already doing charitable contributions, you may want to coordinate some accelerated charitable contributions to minimize the tax bill on the conversion.
ACCELERATING INCOME TAX DEDUCTIONS
Idea number two is designed to address problems with potential and existing limitations to the amount of tax deductions you may be able to take advantage. Potential limitations are based on campaign promises from President Biden while existing limitations are part of the Pease Limitations. Short version is high-income earners may find much less value in deductions.
Let’s get to two specific ideas in this category. First is to accelerate deductions into this year before any limitations are put in place is worth consideration. The second idea is for situations where you want to take advantage of deductions but aren’t sure where charitable contributions should go. The solution here is a Donor Advised Fund. Basically, you are funding the Donor Advised Fund to get the immediate tax benefit, but are dispersing funds to the charities in future years.
LOWER COST-BASIS STRATEGIES
The problem here again is discussion of raising capital gains rates down the road. Some specifics from the campaign include raising capital gains rates from a top level for long-term gains of 20% to potentially 39.6% for those making more than $1 million a year. It may also include the Medicare Net Investment Income Surcharge of 3.8% too.
The first idea is to harvest some gains now based on a lower capital gains rates. The flip side of this is to delay harvesting losses until down the road when they may be more tax advantageous.
Idea two is to set up a Charitable Reminder Trust (CRT). CRTs can systematically digest gains and distribute income over time. If you are interested in this idea, I would definitely recommend talking to your estate planning attorney.
ACCELERATING INCOME INTO THIS YEAR
The fourth idea is as simple as the description I just mentioned – moving future income into this year. Again, the plan is to take advantage of lower tax rates currently on the books.
Some things to consider are exercising stock options this year, selling off some appreciated stock, consider Net Unrealized Appreciation, and/or pushing back business expenses to future years.
LEVERAGE 401k CONTRIBUTIONS: TO ROTH OR NOT
SEI’s fifth and final idea addresses a proposal to limit the 401k tax deduction to a percentage of 26%. While this proposal is beneficial for middle and lower income earners, it limits 401k contribution benefits for higher income earners.
The solution here may be to shift from the traditional 401k of contributing pre-tax dollars and instead go the Roth 401k route. Money would go in after taxes, but no taxes on distributions. Again, taking advantage of lower tax rates in this year. Just a quick reminder there are no income limitations on Roth 401k participation.
Okay, so those are a handful of great tax-smart ideas directly from SEI. Again, be sure to talk to your CPA about any of these ideas. Also, as we get closer to the end of the year we will hopefully have a clearer idea of any potential tax changes that may begin in 2022. Just do NOT wait until Thanksgiving or Christmas to try and make any of these changes as it may be too late. Hopefully your advisor is talking about tax-smart investing throughout the year. I know I am. Heck, my clients know August is when we start doing heavy tax planning. I mean, what better time to talk about taxes than the hottest month of the year.
FLASHBACK – MY DREAM CAR AS A TEEN
I was reminded of today’s flashback as I recently had to buy a new car. I say new, but it is actually a certified used car as I don’t buy new cars. The flashback itself is to a car I dreamt of as a kid, but once I had the chance to buy it I didn’t go for it.
I was infatuated with Jeeps as a kid. Infatuated may be a strong word, but I did try and figure out how much I would need to save a month so I could buy a Jeep when I was 18. I started the calculations when I had my paper route around 12 years old. Oh, and I’m referring to Jeep Wranglers. You know, no top and all that good stuff. I had no interest in Cherokees or whatever else Jeep products there were in the 80s. As far as I was concerned, when you said Jeep you were only referring to Jeep Wranglers.
Unfortunately, I was not a diligent saver of my paper route money nor the money I made while working at the Spaghetti Bender in high school. Heck, I barely made anything the summer at Cedar Point either. Fortunately, I struck gold one summer during undergrad while working at the Wicker Company. I won’t go into deep detail here about that job as I want to give the Wicker Company the proper introduction in other flashback segment. However, the short version is one summer there the owner had a sales event that resulted in me earning a ton over a couple of weeks. Well, at least a ton to a college kid in the early 90s.
Fast forward, I finally had enough money in my pocket to buy a Jeep. Tuition was taken care of as well as my apartment expenses, so I had cash just burning a hole. There was a used car dealership not far from campus. I found out they had some decent used Jeeps there and I decided to do a test drive. I mean, I was ready to buy one.
I found one I liked at a price I could afford. The salesperson had me all set up for a quick test drive. He even took the top off of it so I could get the full experience. I hopped in the Jeep and started the test drive by pulling out of the car lot onto a small side street. There was no speeding, however, I made a turn and let the steering wheel return to a straight position. It was then I realized this was not the vehicle for me. The Jeep jumped all over the road. I’m not sure if that was unusual because it was lightly raining on the test drive, but it made me nervous.
So, although I finally could afford my dream Jeep I decided not to go that route as the car felt too unsafe. However, I did figure out another way to spend that money. I bought a sport bike. Yes, in the mind of a 21 year old male a sport bike was a safer mode of transportation than a Jeep. That’s a flashback for another episode.
As always, thanks for taking the time to read this. Please do not hesitate to reach out if I can be of help with your equity compensation-related questions. The easiest thing to do is to click the little green box that reads “Schedule a Meeting” that can be found at the bottom of every page on my website. Or, just click my Calendly link right here.
I’m Dan Johnson, CFP®, founder of Forward Thinking Wealth Management. I run a flat-fee financial planning and investment management firm located in beautiful Akron, OH. Although I am in Akron, OH, I work with clients regardless of location. I cater to owners of equity compensation positions who are looking to organize their financial lives, keep more of what they make, and do the things they want in retirement and even now.