Three categories of strategies can help reduce your income taxes if rates increase: accelerating income recognition before rates rise, deferring deductions, and structuring your investments to minimize taxes.
1. Accelerate income recognition:
If your tax rate is set to rise after a new tax law, you could intentionally recognize income before the effective date of the new tax law so that you’re taxed on that income at the current lower rate. You can achieve that by:
- Converting your traditional IRAs into Roth IRAs. Distributions from a traditional IRA are taxed as regular income, while distributions from Roth IRAs are tax-free. When you convert a traditional IRA to a Roth IRA, you will be subject to taxes at ordinary rates in the year you convert it. So, if you do the conversion now, you can pay taxes on the IRA at today’s lower rates. Then when tax rates rise in the future, you can take distributions from your Roth IRA tax-free, avoiding the higher rates.
- Selling appreciated assets now to fund your future spending needs. By selling appreciated assets in your portfolio at today’s lower tax rates, you will avoid paying higher taxes later when you need to raise cash. You can even re-buy the assets you sell, which resets their basis. For example, if you withdraw $100,000 per year from your portfolio, and you have over $1 million of highly appreciated Amazon stock, it could make sense to sell $500,000 of the Amazon stock to fund your portfolio withdrawals for the next five years. If you are worried about being out of the market, you can re-buy the Amazon stock or other investments at today’s prices. That way, the tax on the appreciation of that stock will be lower when you sell it later to fund your living expenses.
- Intentionally taking gains in your irrevocable grantor trusts. With an irrevocable grantor trust, only the creator is subject to paying taxes on the trust, and usually, such trusts are not considered part of his or her estate. Because these trusts do not get a stepped-up basis at death, paying taxes on any gains at today’s lower rates will reduce the trust’s tax liability when it becomes non-grantor (meaning that the trust begins to pay its own income taxes – often at the creator’s death). This is good estate planning for two reasons: because the income taxes paid by the trust creator will reduce the assets in his or her taxable estate at death, and the trust will have a lower future tax burden because of its increased basis.
- Opting not to defer income into your deferred compensation plan. If you are an executive or on the board of a company and participate in a deferred compensation plan, you can choose not to defer your 2020 or 2021 income. This would enable you to pay taxes on the income at the current lower rates. Likewise, if you have compensation such as restricted stock that is eligible for an 83(b) election, it may make sense to make that election now before a tax rate increase.
2. Defer deductions:
Given the time value of money, it typically makes sense to take deductions sooner rather than later. However, if you know that taxes will rise, it may be beneficial to defer deductions until higher tax rate years. For example, charitable deductions are easy to defer. You would just give less this year and make it up in future years. Or you could pledge to make future gifts to charities and fund those gifts during higher tax years. However, this planning strategy would only make sense if there’s no 28% cap on deductions. If you own closely-held businesses, you could decide not to elect accelerated expensing and depreciation, and push those deductions into future years.
3. Structure your investments to reduce taxes:
It’s always a good idea to pay attention to the tax drag of your investments, but it will be even more critical under a higher tax regime. You can reduce the taxes on your investment portfolio by:
- Using lower tax realizing investments such as index funds or investment managers that are tax-sensitive or have low turnover and thus have a lower tax drag. For example, tax-managed index accounts are separate accounts that track an index (whether cap-weighted or factor tilted) on a pre-tax basis but generate losses post-tax. Tax managed index funds typically generate capital losses each year (even while keeping up with the market on a pre-tax basis) that you can use to offset gains elsewhere in the portfolio. So, tax-managed index accounts can enhance the tax efficiency of a portfolio.
- Investing inside life insurance policies. Investments inside life insurance contracts grow without tax, and the death benefit is tax-free as well. Also, you can usually make withdrawals without tax consequences. A lower-cost option for large policies is Private Placement Life Insurance. PPLI are custom separate account products that have lower fees than traditional life insurance and much greater investment flexibility. Putting some of your investment portfolios inside PPLI can save significant taxes.
When devising tax planning strategies for clients, I often think of a quote from an opinion written by U.S. Court of Appeals Judge Learned Hand in 1934: “Anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.”
We wholeheartedly agree with Judge Hand that within the confines of the law, it’s entirely appropriate to organize your financial life to reduce your tax burden. Because everyone’s situation is different, the planning strategies we’ve proposed may be great for one taxpayer and not so great for another. That’s why it’s critical to consult your financial and tax planning advisors to determine what’s right for you.