How To Reduce Lifetime Taxes in Investment Accounts

For heavy savers the path of least resistance leads to a massive tax bill. Imagine you do everything right. You are married and you and your partner start saving early, you save 15% of your income with a company match and retire at 62 with $2 million in your 401Ks. Sound great right? Well the problem is YOU don’t own all of that money. Uncle Sam owns a good chunk of it.

All of that money is in tax deferred accounts.  When it is withdrawn taxes are owed on it.  With more and more people choosing to stay heavily invested in equities in retirement the account is probably continuing to grow at $80,000+ a year on average.  Just to get the growth out results in $80,000 of taxable income.  Spending down principal will certainly push you into the 24% tax bracket.

Then we have Social Security.  In this scenario the couple will likely qualify for around $4,000 a month in total Social Security benefits, requiring more taxes to be paid. If AGI and half of Social Security benefits are over $44,000 for a married couple then 85% of the Social Security income is taxable.

This is a big problem with high savers. It’s even worse when they die.  The Save 2.0 act requires all inherited IRA distributions to be withdrawn within 10 years. This creates a massive tax bill for their heirs with no options to reduce the impact.

Another problem surrounding death with most retirement funds in taxable traditional 401K/IRAs? What happens when 1 spouse dies?  The standard deduction and tax brackets get cut in half. This makes affording roughly the same standard of living much more expensive.  Consider getting money out of these accounts as a gift to your spouse as a form of life insurance.

To avoid giving Uncle Sam hundreds of thousands to millions of dollars of your retirement savings action needs to be taken long before you reach retirement.

Most People Need Not Worry:

The median 65 year old has around $200,000 in retirement savings.  With $200,000 it is reasonable to expect around $16,000 in growth per year.  Even with claiming Social Security and working part time this amount of wealth in a traditional 401K can be absorbed into the tax brackets at much lower rates, generally in the 10% and 12% bracket.  Most people who will receive the majority of their retirement income from Social Security have nothing to worry about and don’t really need to make adjustments prior to retirement.  This is a problem generally speaking for the top 10%, and maybe the top 20% of savers.

Step 1: Traditional to Roth IRA Rebalancing:

The goal is to have the highest potential return investments the most tax protected. This means if we have a portfolio of 50% index funds, 10% blue chip stocks, and 40% high growth stocks (like Tesla), then it makes the most sense to have the high growth stocks be held in Roth accounts.

Originally I tried to keep an even mix of everything in each account and this was the wrong method because it did not take this different tax treatment into account. This has already cost me tens of thousands of dollars in extra lifetime tax payments.

I  recently started rebalancing following this strategy. I sold shares of the high growth stocks in my traditional accounts and purchased them in my Roth accounts. I sold the blue chips and index funds in my Roth accounts and repurchased them in my traditional accounts. In 20 years the high growth stocks may be 10X their current value, while the index funds are likely to be closer to 4X their current value. The majority of the growth gets put into the account type that gives the least taxes in the future.

Rebalancing should be done prior to looking for conversions.

Here’s an example using someone with $500,000 of retirement savings with 60% in Traditional accounts, 30% in Roth Accounts, and 10% in an HSA:

Note: The allocated percentages were the same for the traditional and Roth accounts, while the HSA was invested in only Index funds because that is generally the only option. Because the HSA couldn’t be invested in anything but index funds it is 100% in index funds while the other accounts are split 50% Index, 10% blue chip, and 40% high growth. This means the true total allocation is overly weighted to index funds.

Now, after rebalancing the Traditional IRA and Roth IRA this is what it should look like:

• Sell 100% of Roth Index Fund and Blue chips for $90,000.
• Sell $90,000 of Traditional High Growth for $90,000.
• Purchase $90,000 of High Growth inside Roth IRA.
• Purchase $90,000 of Index Funds and Blue Chips in the Traditional.

Step 2: Traditional to HSA Rebalancing:

Most HSA accounts limit investment options substantially. The HSA set up with my employer requires $1,000 to stay in cash and then I have about a dozen mutual funds I can choose from.  HSA owners have the right to move funds to different providers. I have had a total of 4 HSA providers and all have had severely limited options. In the early days it was difficult to find an HSA that allowed investing at all!

I recently opened an HSA account for Mrs. C. and for myself at Fidelity due to Fidelity allowing us to invest in individual stocks in the HSA. I still have my HSA account that my employer setup for me and my weekly contributions go there, but once a year I will be transferring the assets out of this account and into the fidelity accounts. Mrs. C. has an HSA that we started many years ago that has substantial savings in it.

HSAs have tax protection similar to a Roth, and in some cases better.  HSA contributions are made with pretax money, including pretax for Social Security and Medicare tax (If contributions are made through payroll deduction). They also can be withdrawn from early, with NO taxes or penalties due, as long as they are used for medical expenses.  Withdrawals after age 65 can be made with no penalty for non medical usage, but do require paying regular income tax, which essentially is the same tax treatment as a 401K or traditional IRA.

The first major advantage for me for the HSA is that the withdrawals are tax free if for medical, which means I paid no tax on the money when I earned it AND no tax on it when I took it out.  You can also use medical expenses from previous years as long as you have the records and owned an HSA during that time. This means the braces we got for Kid #1 7 years ago count. Mrs. C.’s braces now count.  My ER trip during Covid counts.

The second major advantage for me and any person pursuing early retirement is the ability to withdrawal funds early without jumping through hoops. It is very possible that while I’m still in my 40s I stop working and we want to access some of our paper assets. We will likely have around a years worth of living expenses in HSA qualified medical bills that we can withdrawal.

The move here is to also invest the HSA money into the high growth stocks while investing the money in traditional IRAs/401K into low risk stocks

Using the same example I used above, the resulting rebalance should look like this:

Now that the HSA is free from investment restrictions we can also fully allocate according to our ideal 60% index, 10% blue chip, and 40% High growth

• Sell $30,000 in high growth stocks in the Traditional accounts.
• Sell $50,000 in index funds in the HSA.
• Buy $50,000 of high growth stock in the HSA
• Sell $5,000 in index funds in the Traditional accounts.
• Buy $5,000 of blue chips in traditional accounts.

All of this rebalancing cost nothing, yet it greatly reduced long term lifetime tax burdens.

Step 3: New Contributions:

New contributions also need to take into account the ideal future balance of traditional vs. Roth accounts. For someone not yet ready to do Roth conversions starting to contribute to HSA and Roth accounts over Traditional accounts is a good next step. This stops making the future problem worse. Roth and HSA contributions are especially attractive when the employee is covered by an employer health insurance plan, since income is not tied to the cost of insurance like with an ACA plan.

Step 4: Roth Conversions:

The third step is Roth conversions. This is where we end up paying tax now to ensure we pay no tax in the future.  Roth withdrawals are also not counted for things like ACA insurance subsidies and Social Security taxability.  It is highly beneficial to get the majority of funds transferred out of traditional accounts prior to retirement for high savers.

The sweet spot for Roth conversions is generally between actual retirement and claiming Social Security, at least on a micro level. On A Macrolevel the tax brackets really matter and RIGHT NOW we have historically low tax rates thanks to the Trump Tax cuts.

The first window I talked about is for people who retire prior to taking Social Security.  Generally speaking their primary source of income will be from selling investments in their retirement accounts and potentially some part time earned income. They will be in a lower tax bracket than at the peak of their career and will have available margin in the tax brackets to do some conversions each year to get money out of their traditional accounts.

The second window is right now. For anyone who believes future rates will be higher, the sooner conversions can happen, the better. We have $40 Trillion of national debt and historically low tax rates. It stands to reason that eventually taxes will have to increase. I have begun doing Roth conversions in the 22% tax bracket. I certainly recommend completing Roth conversions in the 10% and 12% bracket for anyone who is there. The 22% bracket is a bit iffy and only makes sense for people who will have substantial income outside of their retirement savings in retirement. For us it is the rental income we have that is driving this decision. I strongly believe that in the next 3 decades we will see significantly higher tax brackets.

With Roth Conversions you can take money out of a traditional IRA and convert it to a Roth by paying taxes in the current year. In a perfect world this is done when your assets are under performing and you have low income for the year.

Our oldest kid is 23 and contributes 100% to Roth accounts, but his employer match is put into traditional. Each year we have him doing an in-plan Roth conversion since he is in the 12% bracket. Anyone in such a low bracket should highly consider doing these in plan conversions.

For our current example that $280,000 in Traditional accounts will likely grow to over $1 million in 20 years. It is wise to get money out whenever possible. If this couple earns $100,000 per year, after the $32,000 standard deduction and another $4,000 deduction for no tax on OT, the couple will have $64,000 in taxable income, putting them in the 12% tax bracket. They have $36,800 of additional income that can be received in the 12% bracket, which they can (and should!) use for a Roth Conversion.  Converting $36,800 per year while assuming 7% yearly gains from the index funds would take around 10 years to empty. Even if they can’t fully empty it ANY progress is good. Each year converting $36,800 in the 12% bracket will cost $4,416 in federal income taxes.

All of this money doesn’t go away. It is transferred into a Roth account and invested in the same assets, but now these assets will grow tax free forever and not count against ACA income limits.

The end of the year is likely not the ideal time to do Roth conversions either. There is often a “Santa Bump” towards the end of the year. Ideally people should strive to perform conversions throughout the year when investments are down to be able to transfer the most shares over with the same amount of money.

For example, if you own 2,000 shares of an S+P 500 fund at $100 a piece in December the total value is $200,000. Converting $36,800 would move 368 shares into the Roth account.  If instead of converting at the end of the year conversions were done automatically when a 10% drop occurs, then with a price of $90 per share then 408 shares could be transferred.

Step 5: Taxable Accounts:

Taxable accounts already sound terrible. Who wants to be taxed? Well taxable accounts have a few advantages that 401K/HSA/Roth accounts do not have. The first advantage is that when they are taxed they are taxed at favorable long term capital gains tax rates (assuming the assets are held for at least 1 year). These brackets for married couples currently are:

• 0%: $0 to $98,900 of taxable income
• 15%: $98,901 to $613,700 of taxable income
• 20% Over $613,700 of taxable income

Overall this is much better than the standard tax rates for earned income that get paid on 401K/IRA withdrawals.

Inside of taxable accounts owners can also practice tax gain harvesting and tax loss harvesting.

For example. Bob buys 100 shares of APPL stock at $300 per share giving him a cost basis of $30,000. 3 years goes by and he hasn’t sold any stock, but his shares have gone up in value to $700 per share providing an unrealized gain of $40,000. For this year Bob and his wife have a total taxable income of $55,000.  They can sell 100% of their apple holdings to harvest this capital gain, then immediately rebuy the same stock.  Since their total taxable income is still under $98,900 they owe no tax on this sale, but have reset their future basis from $30,000 to $70,000.  When they want to take money out of this account in the future none of that $70,000 will be taxable. This process can continually be repeated, shielding large amounts of gains overtime from taxation.

What’s even better? After doing these tax gain harvesting moves over time any cost basis removed from the account does not count as a taxable event, therefore not only is no tax owed, but it also does not affect ACA income limits for healthcare costs. This is especially important for people who retire prior to 65 who can not get Medicare yet.

For tax loss harvesting it works the opposite way. Same example, Bob had 100 shares of Apple that he bought for $30,000 at $300 per share.  This time the stock dropped and shares are trading at $100 per share.  Bob can sell his shares to create a taxable loss to offset capital gains. For example in this year Bob and his wife earned over $100,000 in taxable income AND sold a rental property and were facing having to pay 15% capital gains on the gain of $30,000 from the sale.  Bob can sell the Apple stock at a loss and that $20,000 loss can offset the $30,000 capital gains from the home sale. Now Bob will only have to pay capital gains taxes on $10,000 from the sale of the home.  Bob does have to follow “wash sale” rules and can not rebuy Apple stock for 30 days.

The downside of taxable accounts is that they have very little protection from lawsuits, while retirement accounts, depending on the state are often much better protected. Another downside is that tax laws regarding capital gains taxes are likely to change in the future. The anti-wealth crowd has been salivating at the idea of increasing capital gains tax rates.

What did I miss? What other actions should be taken to reduce future tax liabilities?