Summary/TL;DR
Proactive tax strategies such as capital loss/gain harvesting, making well-planned Roth conversions, taking advantage of qualified charitable distributions, and aligning the tax efficiency of your investments with the tax characteristics of your various accounts, can all save you tremendous amounts of taxes over the course of your retirement.
Introduction
“Tax strategies” are often thought to be out of reach for retirees, whose situations are considered too “simple” for any considerable differences to be made. Fortunately, this is false, and many retirees will find some very impactful strategies well within their reach.
Today’s post will discuss four of my favorites, which are available to almost everybody.
Capital Loss/Gains Harvesting
A capital gain is income derived from selling property (real estate, stocks, bonds, mutual funds, etc) for more than it was purchased. It is equal to the difference between the net proceeds that the property was sold for and its cost basis (which is often equal to its purchase price). For example, if I purchased a share of AAPL stock in my brokerage account for $100 and sold it for $150, then my capital gain would be $50.
Capital gains may be offset by their counterpart – capital losses, which are earned from selling property for less than it was purchased. If capital losses equal capital gains, then capital gains will net to $0 (this has the additional benefit of not adding anything to your taxable income). And if capital losses exceed capital gains in any year, the remainder may be used to offset your ordinary income by up to $3,000 maximum per year. Anything left over after this may be carried forward to future years indefinitely to offset more capital gains or ordinary income.
The intentional realization of capital losses is known as tax-loss harvesting. It works by selling a security and immediately purchasing a different one to simultaneously lock-in the loss and remain invested. When practicing tax-loss harvesting, you must be mindful of the wash sale rule, which says that you may not buy or sell a “substantially identical” security to the one the one that you’ve sold for a loss within 30 days before or after your sale.
Tax-gain harvesting is the intentional realization of a taxable gain that would be incurred within the 0% taxable gain bracket. This effectively resets your cost basis in your property and lowers any potential tax liability in the future. Furthermore, there is no wash-sale rule to have to worry about with tax-gain harvesting.
Proactive use of tax loss and gain harvesting can turn your taxable brokerage accounts into extremely tax-efficient investments.
Roth Conversions
A Roth conversion is nothing more than a transfer of funds from a pre-tax retirement account to a Roth. The gross amount of the conversion is taxable in the year it is made, so great care must be taken to convert an appropriate amount. Once the funds are in the Roth, they will never be taxed again (assuming all other IRS rules are followed). Unlike Roth contributions, there are no income phaseouts or any other form of “limitations” placed on the amount of Roth conversions that one can make, meaning anybody with pre-tax retirement savings can make conversions with no limitations.
Roth conversions will lower your Required Minimum Distributions (RMDs) in the future because they reduce your total pre-tax assets. They will also reduce the amount of taxes your heirs owe when they inherit your accounts. Great care should be taken when making these, however. If you convert too much, you might incur more tax than is necessary or accidentally trigger other taxes, making the conversion less tax efficient than if you had never made it.
Qualified Charitable Distributions
A Qualified charitable distribution (QCD) is a distribution made from your IRA in the name of a charity. The IRA distribution must be made directly to the charity. It cannot go to a bank account or be distributed as a check in the name of an individual. The only requirement for a QCD is that the IRA owner must be 70½ or older in age. Finally, QCDs cannot exceed $100,000 per IRA owner in a single year.
QCDs are effectively a way to make a tax-free distribution from your Traditional IRA. They also, in essence, allow you to claim a charitable deduction without having to itemize your taxes. If you regularly tithe or give to charities, then these can make a big difference to your lifetime tax bill if you take full advantage of them.
Smart Asset Location
The final strategy we’ll discuss today involves consciously holding various investments in different accounts depending on the tax efficiency of the investments, and the taxable nature of the accounts. In general, it’s best to hold low-growth assets, such as bonds or money market funds, in pre-tax retirement accounts, while high-growth assets, such as stocks and Bitcoin, should be held in Roth accounts first, and taxable brokerage accounts second. This strategy maximizes long-term growth in tax-friendly environments and minimizes growth in less tax-friendly ones.
Over time, this strategy can make a huge difference in your lifetime tax bill.
