Who wants to pay fewer taxes? Everybody, of course. Taxes are a part of life, but they do not need to be a burden. Instead, good tax management should be the goal, paying both figurative and literal dividends.
Investor philosophies vary
Investor views on paying taxes cover a broad spectrum. Some are so tax-averse it impairs the ability to make needed portfolio adjustments. Other investors own portfolios where winning investments have run to the point of overbalancing the portfolio and creating concentration risk. Others still take it a step further and cross the line into tax evasion, never sanctioned. Conversely, some investors are so disinterested in or intimidated by their tax situation it causes them to miss beneficial opportunities, such as Roth conversions or contributing to a Donor Advised Fund.
Consider the past and the future
The ideal approach to managing taxes is, as always, somewhere in the middle. Tax management is most effective when seen as an integral part of the investing process. Part of this recognizes the larger picture. Take capital gains, for example. The maximum federal capital gains rate for investments held more than one year is now 20%, though it can be a bit higher if you reach certain income thresholds. From the 1922 introduction of a separate capital gains tax, the highest capital gain rates have occasionally been lower but have been higher far more often. With the large and growing deficit spending behind the COVID-related stimulus bills, taxes are sure to be higher sooner than later. If an investor has a material unrealized capital gain, prudent tax management suggests it might be a better option to pay some of those taxes now rather than in the future.
Balance is best
Investing should be done in tax-smart and tax-efficient ways. When saving for retirement, take advantage of all three legs of your three-legged stool: pre-tax contributions into qualified retirement accounts like a 401k or individual retirement account, after-tax contributions into Roth IRAs or Roth 401k’s, and tax-neutral brokerage accounts. Work to bring these into balance as much as possible.
The retirement saving rule-of-thumb for years was to maximize pre-tax savings because you would be in a lower tax bracket in retirement. With tax rates trending down over the last few decades and likely to start rising, lower tax rates in retirement are no longer a certainty. The objective now should be equilibrium. Striving to bring these three channels into balance will provide the needed flexibility to manage whatever tax regimes are in place at retirement.
What can long term tax planning look like?
Sometimes these legs can be wildly out of balance, and a tax management plan can add tremendous value. Say you are a 60-year-old individual whose 401k holds shares of your employer that have appreciated outrageously during your employment. And you have had limited access to Roth accounts. While age 72 and required minimum distributions (RMD) are several years away, you can see how big those distributions will be. You are concerned about the tax burden in retirement and any that might fall to your heirs. You also know your RMDs will be far more income than needed. You might then consider a series of Roth conversions spreading those tax payments over a broader period rather than bunching the tax payments in your retirement years. This is what long-term tax planning can look like.
Taxes are a necessary consideration of your financial landscape. A combination of critical thinking and thoughtful analysis can minimize their long-term claim on your assets.