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Income Tax Planning: Beyond the Shortsighted

BFG Whitepaper February 2019

When thinking about income tax planning, most individuals think in terms of the current tax year versus the upcoming tax year.  Taking a broader and longer range view over an income tax lifetime can provide more meaningful savings, but is rarely calculated due to the complexity. Although a great deal of effort and knowledge is needed, along with careful assumptions being made, we find that significant income tax avoidance and wealth preservation can be achieved by strategizing intentionally over multiple years. 

This paper is meant to give an overview of some of the tax planning tools we use, but not get lost in details or exceptions that exist depending on each situation.  Please consult with your tax advisor before taking action. 

Overview of Tools Explained:

  • Deferral versus avoidance
  • Low bracket years
  • Long-term capital gain
  • Roth conversion
  • Account types & asset class
  • Charitable intent

Tax deferral vs. tax avoidance is a commonly confused and misunderstood area of tax planning. As the names imply, tax deferral simply means avoiding paying tax today, but the tax will be paid later under most circumstances. Tax avoidance on the other hand is a permanent phenomenon and is much more valuable: never paying tax versus paying it later. Advanced income tax planning usually focuses on lifetime income tax avoidance and minimization rather than simple deferral alone.

Most individuals and tax preparers have a short range of time to analyze and project current year taxes plus one tax year into the future.  Below is a simple example to help convey this type of logic:

  • After retiring, Kathy, age 68, works part time at a flower shop. She lives on this modest income plus some withdrawals from her savings account, and plans to do this until age 70. Assuming she’s in a 12% income tax bracket this year and next, she could contribute part of her earnings to an IRA
    (ex: $3000/year). By making this tax deductible contribution, Kathy would save 12% ($360/year) in taxes. Seems like a great idea, right?
  • Asking more questions is imperative. The bigger picture is that Kathy delayed collecting Social Security until age 70 for maximum payment, and that the IRS forces people to take required minimum distributions from their IRA/401(k) accounts starting at age 70.5. Both of these create more taxable income, and therefore her tax bracket will be, for example, 22% or higher for many years to come. Even though she gets to save $360 dollars this year and next, she will likely pay the equivalent of $660*2=$1,320 of tax in the future. The changing income tax bracket makes the IRA contribution less than ideal in this case.


  • What could have been done differently? In this example, if Kathy had contributed to a Roth IRA account, she would have received zero tax deduction in the first two years, and paid the $300/yr in income tax. After those years, if she needed money she could take from her Roth IRA account which is not taxable income. Therefore, this would be a tax free withdrawal, saving $1,320 that would have otherwise been due.  The difference between the two solutions is $600 on $6,000, the 10% difference in tax rate between the years (any ROTH earnings are tax free as well).

Although this is a relatively straightforward example, we see that there is a major difference between a seemingly simple decision to contribute money to a Roth IRA versus a Traditional IRA. Over the lives of many retirees this one type of logic can easily add up to $25,000 or more.  In higher income/net worth examples, the difference can be much greater.

Beyond the example, income tax bracket planning is fundamentally one of the primary tools that a long-range tax planner utilizes. Even during early savings years, middle-age, pre-retirement, and post retirement, most people’s lives have a variety of income tax brackets, and this can be used as a powerful tool to avoid overall tax, but requires careful thought and planning.

The next category of tax avoidance & efficiency relates to Long Term Capital Gains.  Did you know that many investment gains that normally create an income tax burden would be lower-tax or even tax-free if they are held for a year and a day or longer?  This only applies to assets held outside of retirement accounts, i.e. what is commonly referred to as nonqualified accounts. This means that holding certain assets in these type of accounts, if watched carefully, can allow people to earn profits without paying as much tax.  These ideally would be ‘buy and hold’ type investments.  More on this in the ‘account types & asset class’ discussion below.

Thinking longer-term, if a person or family has a low income tax year or years, say in between jobs or between retirement & beginning income from Social Security/etc., there are ways to purposely trigger taxable income to use up the low income tax brackets. If a tax situation has a few years of 12% tax bracket for example, and we know that it is highly likely that the same situation will be at least in the 22%+ income tax brackets in the future, it makes sense to trigger Long Term Capital Gains. Another option would be to convert money from IRA accounts into Roth IRA accounts, which creates tax on every dollar moved over [a ROTH conversion]. This may seem counterintuitive, but it is a way to minimize total tax paid over a lifetime by choosing to pay tax in low bracket years rather than high bracket years.

Account types & asset class: A complex and meaningful method of long-range tax planning is to concentrate certain investment strategies in tax efficient accounts such as IRA, Roth IRA, or after-tax nonqualified money.

  • IRA/401(k): In general, after receiving the tax deduction for contributing to this type of account, it is the worst place to have dollars invested because you will eventually pay tax on every dollar there and all growth in the future. These are still appealing accounts because of the upfront tax benefit when contributions are made and that full taxability happens eventually [in most cases]. Generally the more conservative slower growth assets, or any strategy that is tax-inefficient, is appealing to hold within the IRA title.  Common examples of this include bonds, and many more conservative alternative investment strategies.
  • Roth IRA: Contributions receive no tax deduction, but every penny that’s there as well as all future growth is tax-free when it is withdrawn later in life. For this reason we prefer higher growth assets in Roth IRAs. This includes stocks of all kinds, specifically small companies (both US and abroad), as well as emerging markets. These tend to have the highest long-term growth rates and the most volatility, making for a wild ride, but for the best long-term expected rate of return. Roth IRA would also be a good place for many aggressive alternative strategies.
  • After-tax ‘nonqualified’ assets: Typically here we like investments that pay tax advantaged income such as municipal bonds, stocks that pay ‘qualified dividends’ (which are taxed at Long Term Capital Gain rates rather than Ordinary Income rates), many real estate investments, and tax efficient long-term ETFs.

Charitable Intent:  if a person or family has an intention of giving a part of what they’ve earned and saved during life to a charity, there are important tax strategies that can help maximize the after-tax benefit for charities as well as family.

  • For example, if a person passes away and the beneficiary of their IRA is their child, the child will pay income tax on every penny that they inherit when withdrawn; however, if a charity receives an IRA, they will get its full value without ever paying income tax so long as they are a charitable entity, 501(c)(3).
  • A Roth IRA, on the other hand, is tax-free to both individuals and charities making it a comparatively better account to pass on to individuals.
  • Nonqualified accounts (under current law) usually receive a ‘step-up in basis.’ This means gains would vanish at the moment the owner passes away, making these accounts often beneficial for inheritance purposes.
  • In more advanced situations there are Trust-based strategies that are hugely appealing, but larger dollars are often needed in order for this to make sense.

Charitable part two: the Donor Advised Fund.  One more very powerful planning tool for people that have charitable intent is called a Donor Advised Fund.  It allows large upfront contributions in one tax year, which is especially useful if they have a big bonus or other income producing event that’s abnormal, because the tax deduction all occurs during one year.  This aspect has added benefit after the recent tax law change. At any point in the future, a person can distribute money from the donor advised fund to the charity of their choice and spread it out over any number of years. Of course, a second tax deduction is not received, but this allows them to bunch-up charitable gifts together for maximum overall tax benefit.  Especially beneficial is contributing assets to a donor advised fund that already has large gains, thus avoiding those capital gains.

Tax planners have a number of different tools at their disposal. These tools are an integral part of investment portfolio construction and need to be carefully reviewed for each person’s situation. Combining all of these areas gets to be extraordinarily complicated, especially with the long-range tax bracket planning. Most consumers are unable to take full advantage. This leads to a terrific opportunity for savings that many people simply don’t pursue.

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