I’ve been working with financial advisors a lot recently on how to implement better after-tax strategies for their doctor, lawyer, and business owner clients who are in high marginal tax brackets. Such strategies are especially important for clients who are near retirement and are heavily invested in the bond markets which are low-yielding, highly taxable, and subject to interest rate risk.

If you’re a high earning professional subject to high tax-rates, below are 5 financial planning strategies you can implement on your own or with the help of a financial advisor in order to increase your after-tax wealth for retirement or for passing money tax-free to your children.

1. Utilize asset location in your investment planning

Asset location merely means putting your stock and bond investments into the structure that minimizes their tax-liability. This means putting your stock investments in your taxable accounts and your bond investments in your retirement accounts.


Asset location chart
Asset Location:

By placing stock investments in taxable accounts and bond investments in retirement accounts, you can minimize taxes on these assets.


The reason for this is that if you invest in stocks in a taxable account, you already get tax-deferral on the appreciation (no taxes are due on the appreciation until you sell the stock) and you pay a lower long-term capital gains tax-rate on the gains. However, if you invest in stocks within your retirement accounts, while you still get the tax-deferral, you will most likely pay a higher ordinary income tax-rate when you take the gains out.

Bond funds typically distribute most of their gains each year—which means they are subject to ordinary income taxes. If you’re a working professional subject to high tax-rates, not only are the yields on these low, but you’re also paying high taxes on the gains each year leaving you with very little after-tax return. By placing bonds in your retirement account, you get to defer these gains until you are in retirement and will typically be in a lower marginal tax bracket.

2. Don’t accumulate wealth in your tax-deferred retirement accounts; do so in your taxable accounts:

Most people don’t realize that if you accumulate a lot of wealth in your tax-deferred retirement accounts (401k, traditional IRA, etc) and you pass away, that your children who will inherit your assets will pay ordinary income taxes on the gains (since all the gains were tax-deferred to begin with). However, if you accumulate wealth within your taxable accounts (or tax-free Roth IRA), your children will get to keep all the gains tax-free through a rule known as step-up-in-basis!

Here’s a quick math example. Let’s say you buy $10,000 worth of Apple shares today. Let’s assume you live for another 30 years and that those shares appreciate to $100,000. That’s $90,000 worth of gain.

If those shares are in a taxable account, your beneficiaries will get to keep that gain tax-free when they inherit it. However, if those shares are in your retirement account, your beneficiaries will have to pay ordinary income taxes on the gain (remember they don’t get to pay the lower long-term capital gains rate on those shares because they were held in a retirement account)!

So any investments you plan on passing on to your children should be kept in a taxable account. Anything in your retirement account you should plan to spend down completely while you are alive.

3. Defer taxes on bond gains until you are in retirement.

As we mentioned earlier, you want to try and get all your bond investments into retirement accounts so that you can defer the gains on those investments until you are in retirement—when you will be in a lower tax-bracket. At that point, you can withdraw these gains prior to having to take required minimum distributions (RMDs) or receiving social security so that these gains will be taxed at lower rates.

 


Tax Deferral Benefits
Tax Deferral:

By deferring paying taxes on gains while you are in a high marginal tax-rate during your working period, you can pay a significantly lower tax-rate if you pay the taxes on them over time while you are in a lower tax bracekt in retirement.


The problem is that many high-earning professionals are limited in their ability to contribute to tax-deferred vehicles because of their high income. Some strategies that high-earning professionals can use to bypass this include: SEP IRAs and Solo 401ks individually or combined with Roth IRA conversions, no-commission annuities, guaranteed lifetime income, and indexed-universal life insurance.

The added benefit of doing a Roth conversion is that if you convert a traditional IRA to a Roth IRA and leave it in there for 5 years, you can take out your contributions without a penalty. In the absence of this, there would be no way to do a withdrawal from your traditional IRA before age 59.5 and paying a 10% penalty.

The downside of doing a Roth conversion is that you’ll have to pay taxes on the gains today. So if you need access to your retirement funds early, doing a Roth conversion might be a great way to do so—especially since all gains after you do the Roth conversion will be completely tax-free.

4. Determine the appropriate asset allocation for yourself and use low-cost index funds

There are tools to help you determine the appropriate percentage of stocks and bonds you should hold in your portfolio (asset allocation) depending on your current age, retirement age, savings-to-date, and risk tolerance.

One such tool is Vanguard’s Asset Allocation Tool. While these tools can be more generic and one-size-fits-all as opposed to having an advisor do a detailed review of your assets/risk profile, such tools can provide good general direction on what percentage of your portfolio you should be putting in stocks versus bonds.

Once you’ve decided on the right stock/bond portfolio allocation, there are a number of low-cost index funds provided by Vanguard, Schwab, Fidelity and others that you can use to help accrue wealth.

Want to learn more tax-efficient financial strategies you can implement yourself or what to look for in a financial advisor who could help you better implement these strategies?

Then watch our webinar: Do I need a financial advisor or can I do it myself?

Premium Minimization

Premium Minimization

Premium Minimization Services One of the main concerns of life settlement investors is minimizing the premiums required to keep the policy in force. Colva is a specialist in utilizing actuarial principles...

We are actuarial and insurance experts that structure low-cost/no-commission solutions to fit clients’ financial plans