3 Tax Planning Moves That Could Save You Millions

zach5896
7 days ago
5 min read

These three strategies, when properly implemented alongside a professional, have the potential to save you 7-figures in taxes over the course of your lifetime.

Asset location
Withdrawal sequencing
Tax rate arbitrage

Today’s post will discuss them all in detail.

Asset Location

Asset location refers to the placement of different investments in specific types of accounts based on the tax-efficiency of the investment and the tax characteristics of the account. The goal is to align the two by placing each investment within the account that is optimal for it.

For example, bonds are notoriously tax-inefficient investments with interest being taxed as ordinary income. They are also low growth investments.

These two characteristics of bonds make the optimal place to hold them pre-tax retirement accounts where the interest will be tax deferred and the low growth will work to minimize Required Minimum Distributions (RMDs) that will take place later in retirement.

Stocks, on the other hand, are generally far more tax efficient. First, they pay dividends (instead of interest) which can qualify for favorable tax treatment. Second, they are likely to experience high degrees of long-term growth which can be taxed at favorable capital gains rates instead of ordinary income rates.

This makes stocks a great fit to be held in Roth IRAs and taxable brokerage accounts. Roth IRAs will not only subject all of their growth to tax-free treatment, but they also aren’t subject to RMDs, so the growth won’t come back to bite you late in retirement.

In taxable brokerage accounts, on the other hand, capital gains can be deferred until the point of sale when they can be taxed at favorable capital gains rates that can be as low as 0% for retirees. They can also be avoided altogether by borrowing against the assets within them through margin loans which can be very powerful if you use them responsively.

In my practice, asset location is determined every year in every client’s “Portfolio Design Report”. Below is an example from the asset location section of this report for sample clients, Michael and Holly Scott:

Assuming they live until they’re 100, this single change could save Michael & Holly $2.2M in taxes because of reduced RMDs and getting income taxed at more favorable tax rates.

Withdrawal Sequencing

Withdrawal sequencing refers to being intentional with how you draw funds from your portfolio to create your income in retirement.

Every dollar taken from a pre-tax retirement account such as an IRA is going to be taxed as ordinary income. While this income can be offset by deductions it will almost always impact your Modified Adjusted Gross Income (MAGI) which can have a multitude of negative downstream effects once certain thresholds are passed. Examples include higher amounts of social security being taxed, higher Medicare premiums, or being phased out of eligibility for the new Senior Deduction.

There is one noticeable exception to distributions from a pre-tax account – Qualified Charitable Distributions (QCDs). If you’re over 70½, you can make charitable donations directly from your IRA and those distributions will not be counted towards your ordinary income even if you don’t itemize your taxes!

Distributions from Roth IRAs, on the other hand, are 100% tax free and will have no impact on your MAGI! This generally means distributions from these accounts should be taken last when no additional income, whether it’s ordinary income or capital gains, is desired.

Finally, we have taxable brokerage accounts. These are after-tax accounts, so distributions are tax-free but capital gains incurred from selling assets to fund distributions will be subject to capital gains taxes. Fortunately, long-term capital gains tax rates are highly favorable when compared to ordinary income tax rates and can be as low as 0%.

Generally speaking, the optimal withdrawal strategy will be to prioritize distributions from taxable accounts first up to certain capital gains thresholds. Distributions from pre-tax accounts can be taken in small amounts up to deduction and MAGI thresholds with any remaining amount of income being taken from Roth accounts.

My preferred way of implementing withdrawal sequencing is typically to take all income from taxable accounts first and complete a Roth conversion with pre-tax accounts up to our desired MAGI for the year. Roth accounts are left in place for later-life spending and passing assets tax-efficiently to heirs.

Optimal withdrawal sequencing, when combined with optimal asset location, will save the Scott’s $3M in lifetime taxes if they live until they are 100:

Tax Rate Arbitrage

Tax rate arbitrage refers to selectively timing when you realize taxable income throughout your life with the objective of realizing higher amounts in lower tax years and lower amounts in high tax years. This is principally accomplished through 401(k) plans and Roth conversions.

The key here is realizing that you are likely to be in a much higher tax bracket while you’re working than you will be in when you retire, especially in early retirement before RMDs kick-in.

This presents you with an incredible opportunity – defer taxes into your 401(k) pre-tax at higher tax rates while you work, invest the tax savings in a brokerage account, then convert your 401(k) to Roth in early retirement at lower tax rates using the brokerage account to pay the taxes on the conversion. The difference in tax rates (arbitrage) is lifetime tax savings to you and your heirs.

Look at Michael and Holly’s example below. The blue shaded area is their projected taxable income in every year of their life with no conversion strategy. The green is what their projected taxable income becomes with a conversion strategy in place.

See how they are voluntarily paying taxes at the lower tax rates they’ll be experiencing in early retirement in exchange for avoiding far higher rates that they would otherwise experience later on? This, when combined with their other strategies implemented above, is projected to save them $8.4M in taxes if they live until age 100.

Tax arbitrage is by far the most powerful tax strategy available to most retirees and can save them millions in taxes over the course of a 30-40 year retirement. They also have the potential to save hundreds of thousands in Medicare premiums by reducing the impact of IRMAA surcharges on their Medicare premiums.

Roth conversions increase your MAGI, so you should never do these without the help of a professional who can confirm that you aren’t exceeding thresholds that you don’t want to which could lead to the conversion costing you more than it will save you.