Death and taxes, as we all know, are the inevitabilities in life. We spend a lot of time and energy avoiding the former and almost as much mental capital trying to prevent the latter. But should we? As unpleasant as they are, taxes are born out of a successful endeavor where we earned or won money in some form. That being said, you should still be “tax-aware” with your finances to minimize the drag that taxes have on your bottom line. After all, we don’t want to line Uncle Sam’s pockets unnecessarily.
Don’t let the tax tail wag the investment dog. I frequently encounter situations where somebody has made prudent investment decisions in their taxable account and is now the proud owner of unrealized capital gains. Too often, people are hesitant to sell some or all of these successful investments because they will have to pay taxes on those gains. Unless the goal is to admire the balance in your investment account, you will have to sell at some point to be able to spend that money. The surefire way to avoid paying taxes is to let the investment decline in value. Not ideal. We want to be prudent with managing the risks in our portfolio without letting taxes prevent action. Being proactive about tax-loss harvesting and asset location can also help offset some of the tax burden. Unsure what this entails? Reach out with questions.
As part of a “tax-aware” strategy, it is imperative to take advantage of tax-advantaged accounts. Government legislation has created a variety of tax-advantaged accounts that assist individuals in reducing their tax bills. However, be careful – they usually have a catch. Typically, taxes and penalties may apply if you try to use the money for anything other than the account’s intended purpose (retirement, education, healthcare). Most people are aware of the 401(k) or other employer-sponsored plans, so I will take this opportunity to highlight two of my other favorites.
A Roth IRA allows money to grow and be withdrawn tax-free, assuming specific qualifications are met. I’ve written here before about the versatility and benefits these accounts provide, but it is worth highlighting again. It can also be used as a hybrid emergency/retirement fund since contributions (not total account value) can be withdrawn, without taxes or penalties, at any time. For those who may not qualify for contributions based on their income level, there are other ways to get money into this type of account. I’m just skimming the surface for brevity, but I recommend exploring these accounts in more detail.
I believe another underutilized account is the Health Savings Account (HSA). Contributions into this account are only eligible for those enrolled in a high deductible healthcare plan, but the benefits cannot be understated. Contributions to, and distributions from, an HSA are entirely free of federal, state, and Social Security/Medicare taxes as long as they are used to pay for qualified medical expenses. That’s right, completely tax-free on the way in and the way out. Additionally, account balances above a certain level are typically eligible to be invested for long-term growth. For added versatility, non-medical distributions can occur after age 65, with the only difference being that the distributions are taxed (not penalized).
Astute readers and fans of classic rock noticed the allusion to the famous Blue Oyster Cult song, “(Don’t Fear) The Reaper” in the title of this piece. The song deals with embracing the inevitability of death to get on with your life. In a similar vein, shifting your focus regarding taxes can help you enjoy the fruits of your labor and investments. Proper tax planning can help mitigate the impact of taxes on your financial picture, and working with a financial advisor can help identify missed opportunities.
Author: David Rath, CMT, CFA
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