Become a Tax Savvy Investor

It’s tax season! Many investors hate taxes, but I enjoy the challenge of minimizing them.

Federal District Court Learned Hand stated the following in 1934:?

“Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.”

History of Tax Rates in the U.S.

In 1944 the top federal tax rate was over 90 percent. In 1965 it was reduced to 70 percent. Between 2003 and 2012 it was 35 percent, and it rose to 39.6 percent in 2013 before being reduced to the current 37 percent effective January 1, 2018. The January 2018 tax law changes were scheduled to “sunset”, on December 31, 2025, but it appears (based on the new administration and reports from government officials) they will be extended.

Know Your Marginal and Effective Tax Rate

Whether you prepare your own taxes—or whether you have a tax preparer—review your 2023 or 2024 tax return carefully, and determine what rate you are paying. These may be summarized for you on the tax return or on TurboTax?.

If not, calculate the following:

Your Marginal Tax Bracket: Take the figure labeled as “taxable income” from line 15 of your most recent 1040 federal tax return, and look online for a chart of marginal tax brackets. Determine if your taxable income places you in the 10, 12, 22, 24, 32, 35, or 37 percent marginal tax bracket. Let’s assume you are in the 24 percent marginal tax bracket. This does not mean you pay 24 percent taxes on all of your income. Our tax brackets are “gradated” so higher income people pay a higher tax rate, but only on a portion of their income. Someone in the 24 percent marginal bracket will pay taxes on a portion of their income at the 10, 12, 22, and 24 percent rate.

Your Effective Tax Rate: In my view, knowing the effective tax rate is far more valuable than the marginal tax bracket, because the effective tax rate is the “average” tax rate you are paying on all of your income. To calculate your effective tax rate, take your “total tax” (line 24 from your 2023 or 2024 tax return) and divide it by your “taxable income” (line 15). Multiply the result by 100 to get your effective tax rate. You will find that your effective tax rate is significantly lower than your marginal tax rate.

Strategies to Reduce Your Taxes (Ongoing)

Keep your taxable investment accounts tax-efficient to minimize taxes. This is especially important if you are in a high marginal tax bracket (roughly 24 percent or above).

• Index funds tend to be much more tax-efficient than actively managed mutual funds, so use low-cost index funds in your taxable accounts.
• Consider using municipal bonds (or muni bond funds or ETFs) in your taxable account, rather than other types of bond funds which distribute taxable income.
• Consider “tax loss harvesting” in your taxable accounts, which involves selling an asset at a loss in order to use the loss on your taxes.
• Hold investments in your taxable accounts at least one year, to qualify for favorable long-term capital gains tax rates when you sell an asset with a gain.

Long-term Strategies to Reduce Your Taxes????? ?

Traditional 401(k)s and IRAs provide an opportunity to contribute on a pre-tax basis, and many employees funded them to the maximum amount allowed each year. They were doing what was recommended, and they were saving for retirement. This is great while the accounts are tax-deferred during the working years. However, when the accounts become very large (perhaps over $500,000), it can cause a tax problem. This is because withdrawals will be taxed (as income) whenever a retiree takes a withdrawal, and withdrawals are required beginning at age 73 (age 75 for persons born after January 1, 1960). These are called “Required Minimum Distributions” or RMDs.

Many financial advisors are now seeing clients with 401(k)s over $1 million, and the impending tax problems have become apparent. People were told they would be in a lower tax bracket when they retired, but this is often not true. Social Security income is taxable, and many people have pensions or annuities that are also taxable, in addition to the RMDs. In 2007 Medicare premiums changed, so high-income earners pay much higher Medicare premiums (called IRMAA). The net effect is that retirees can find themselves paying high taxes and high IRMAA during retirement.

The 1998 Introduction of a Better Mouse Trap: The Tax-Free Roth IRA

One way to reduce the high income and high taxes during retirement is to stop funding the pre-tax retirement plans, and fund the after-tax accounts (called Roth 401(k)s or Roth IRAs) instead. Investing as much as possible in tax-free Roths is wise. This change will increase your annual income because you will no longer have a tax deduction for the pre-tax contributions. However, the long-term benefit will be lower income (and therefore lower taxes) during retirement, with the added benefit of many years of tax-free growth.

Another strategy is to convert traditional 401(k)s or IRAs to the Roth version, but this requires paying taxes on the amount converted in the year converted. I have written about the many benefits of Roth retirement accounts several times, and past articles can be found on my website at donnaskeelscygan.com under “Articles.” One benefit is that Roth IRAs do not have RMDs, and withdrawals from a Roth are tax-free.

Although paying the taxes in the year of a Roth conversion is painful, the long-term benefit of moving the money to a tax-free account can be significant. The Roth IRAs also provide estate planning benefits because your heirs will inherit the Roth tax-free, which is not true of a traditional IRA.

Another tax strategy is to look for a low-income year as an opportunity for a Roth conversion. If you are planning to retire, but you will have a delay before starting social security benefits or before being required to take RMDs, this may be an opportune time for a Roth conversion. Roth conversions can be spread over many years. IRMAA (Medicare penalties) are based on your modified adjusted gross income two years before starting Medicare at age 65, so this timing also needs to be considered. The Social Security Administration (which oversees IRMAA) is always working on a two-year delay.

Tax preparers and financial advisors have tax software to help you analyze potential Roth conversions, and TurboTax? can also help. Taxes can be very complex, and there is no indication they will become simpler. Looking for ways to minimize your taxes in the future is a worthwhile venture.

Donna Skeels Cygan, CFP?, MBA is the author of The Joy of Financial Security, and her upcoming book Becoming Enriched. She owned a fee-only financial planning firm in Albuquerque for over 20 years before recently retiring. She welcomes emails from readers at [email protected]. Prior columns are available at donnaskeelscygan.com/articles/.

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