This article provides a summary of topics from a Milestone webinar on various tax planning strategies, including retirement accounts, Roth conversions, equity compensation, and efficient charitable giving. Hosted by our advisor Kyle Labelle, the full recording is available on YouTube or through our website’s “Videos“ section. While we encourage everyone to watch the complete webinar, you can also use this article to jump to specific sections of the recording by clicking the time stamp in each section header. 

Income Tax System (03:49)

The federal income tax was established with the passage of the 16th Amendment to the Constitution, granting Congress the authority to tax income “from whatever source derived.” This means that all income is taxable unless specifically exempt. Since then, tax laws and rates have continually changed. Understanding this historical context is crucial for tax planning, as it helps us assess our current position in relation to the past and make informed predictions about future tax policies. A person’s expectations about the direction of tax policy will influence their present financial decisions. 

Another key element of the income tax system is IRS Form 1040, which nearly every American, or their tax preparer, must complete and file by April 15 each year. This form provides a summary of the taxpayer’s financial situation for the year, including all income, deductions, credits, and payments. While it may seem complex, the information can be simplified into an easy-to-understand “tax flow,” as seen below. We recommend reviewing your own Form 1040 to gain a better understanding of your finances and the overall income tax system. 

Gross Income – Adjustments = Adjusted Gross Income (AGI) 

AGI – Deductions = Taxable Income 

Taxable Income x Tax Rate* = Tax 

Tax – Credits = Total Tax 

Total Tax – Payments = Tax Owed/Refund 

*Note: The income tax rate is progressive, meaning that as taxable income rises, so does the rate at which additional dollars are taxed. The applicable brackets can be found on our website at Crunching Number$. 

What Is Tax Planning? (11:56) 

Tax planning aims to minimize your lifetime tax burden by considering both your current financial situation and anticipated changes in personal circumstances and tax policy. In essence, it’s about long-term tax avoidance, which should not be confused with tax evasion or fraud, as tax avoidance is entirely legal. Also, it’s important to refer to it as “planning,” not “a plan,” because it is an ongoing process that requires regular adjustments over the course of many years. A static plan will quickly become obsolete. Remember, the goal of tax planning is to reduce your overall lifetime tax burden, not your tax liability in any single year. 

Avoiding Penalties and Interest (16:42)

One of the simplest forms of tax planning is to avoid unnecessary penalties and interest. Two of the most common penalties are the “Failure to File” and “Failure to Pay” penalties. The specifics are as follows: 

• Failure to File: This penalty applies when you owe taxes but fail to file your return by the deadline. The penalty is 5% of the amount owed per month, up to a maximum of 25%. 

• Failure to Pay: This penalty occurs when you file your return on time but don’t pay the taxes due. The penalty is 0.5% of the unpaid amount per month, also capped at 25%. 

In both cases, you will also owe interest on the unpaid amount at prevailing rates. To avoid the Failure to Pay penalty, the IRS requires that taxes be paid throughout the year on a quarterly basis. Safe harbor rules determine how much tax must be paid each quarter to avoid penalties based on the following thresholds: 

• The lesser of 90% of the current year’s tax liability 

• 100% (or 110%, depending on your AGI) of the prior year’s tax liability 

• Nothing, if you owe less than $1,000 

You can meet the safe harbor requirements by withholding and/or making estimated tax payments. 

Maximizing Tax-Advantaged Retirement Plans (19:01)

There are many types of retirement plans, but the advice remains the same for all of them: Take full advantage! These accounts allow you to set aside a limited, yet significant, amount of your hard-earned money to grow tax-advantaged. You can choose between receiving a tax deduction today or making tax-free withdrawals in the future. Regardless of your choice, all income earned on the contributions is deferred, meaning you won’t owe additional taxes on earnings from interest, dividends, or capital gains in the present year. 

First is the employer-sponsored defined contribution plan, which includes 401(k), 403(b), 457, and Thrift Savings Plan accounts. For-profit companies typically offer 401(k) plans, while nonprofit organizations and state or local government agencies provide 403(b) plans, among others. These plans allow payroll-deducted contributions of up to $23,000 annually, with an additional $7,500 in catch-up contributions for individuals over age 50. 

In contrast, individual retirement accounts (IRAs) are not tied to an employer but still require earned income at least equal to the amount contributed. In 2023, the maximum IRA contribution was significantly lower, capped at $7,000, with an additional $1,000 permitted for those over age 50. Unlike employer-sponsored plans, IRAs may be subject to income phaseouts, but they offer greater flexibility and more investment options. 

Be aware that pretax retirement accounts are subject to required minimum distributions (RMDs). This means that upon reaching a certain age, you must start withdrawing money from the account, which increases your taxable income. The amount you are required to withdraw is determined by your account balance and life expectancy, as outlined in an IRS table. RMDs are designed to prevent the indefinite deferral of income taxes. If your RMDs exceed the income you actually need, including other sources, you could be pushed into a higher tax bracket. Effectively managing RMDs is a key aspect of tax planning, which is why tax planning in retirement is just as important as it is while you are working. 

Traditional vs. Roth (24:52)

There are three types of contributions you can make to a retirement plan: traditional, Roth, and after-tax. Unless you’re pursuing a specific strategy (which will be discussed later), we generally don’t recommend after-tax contributions. Instead, let’s focus on the first two: traditional and Roth. 

Traditional Contributions: 

• Reduce your current year’s taxable income 

• Grow tax-deferred 

• Are taxable upon withdrawal 

• Are subject to RMDs 

Roth Contributions: 

• Do not reduce your current year’s taxable income 

• Grow tax-deferred 

• Are tax-free upon withdrawal 

• Have no RMDs 

Although everyone’s situation is unique, there are a few general rules of thumb. Roth contributions usually make the most sense when you’re early in your career, younger, or earning less than you expect to in the future. In contrast, traditional contributions may be better during your peak earning years or when you’re making more income than is average for you. 

Since it’s hard to predict your future financial situation, do not discount the benefit of having a mix of accounts with different tax statuses. This will give you valuable flexibility when managing taxes down the road. 

Mega Backdoor Roth (27:38)

The mega backdoor Roth allows you to contribute more than the standard limit to your 401(k). Note that this option is only available for those with a 401(k) plan, as other employer-sponsored plans usually don’t offer this feature. Here’s how it works: You make after-tax contributions to your plan and then execute an in-plan distribution to convert those funds into a Roth account. 

When using this strategy, you can contribute up to $69,000 in total, compared to the typical $23,000 contribution limit. Keep in mind that not all 401(k) plans are set up to allow this strategy. However, if your plan supports it, the mega backdoor Roth is one of the most powerful strategies for maximizing tax-advantaged growth. 

Backdoor Roth (32:16)

A Roth IRA has income restrictions that prevent higher earners from contributing directly. However, the backdoor Roth offers a workaround. Unlike the mega backdoor Roth, this strategy doesn’t involve an employer plan. You just need to ensure you don’t have any funded traditional IRA accounts. Simply make a nondeductible after-tax contribution to an empty traditional IRA and then convert that traditional IRA balance into a Roth IRA. 

Since you didn’t claim a deduction for the IRA contribution, the conversion is not taxable. This strategy allows you to bypass Roth IRA income limits by turning your nondeductible IRA contribution into a Roth contribution, enabling tax-free growth and withdrawals. 

Roth Conversions (33:40)

Roth conversions involve moving money from pretax accounts, such as traditional IRAs or employer-sponsored plans, into a Roth account. Since the funds in these accounts haven’t yet been taxed, the conversion triggers a taxable event, meaning you’ll owe ordinary income tax on the amount converted. From that point, all growth on the converted amount will be able to be withdrawn tax-free. This strategy is an example of income acceleration and typically makes sense if you believe you can pay taxes at a lower rate now than you would in the future. 

Health Savings Accounts (34:44)

A health savings account (HSA) is one of the most effective accounts available. What makes it unique is that it combines the best features of both Roth and traditional contributions. You get a triple tax advantage: contributions are tax-deductible, growth is tax-deferred, and withdrawals are tax-free! However, there are a few requirements to keep in mind. To contribute, you must be covered by a high-deductible health plan, which includes a deductible of at least $3,200 for a family plan in 2024. Additionally, tax-free withdrawals are only allowed for qualified health-related expenses. We often advise our clients to pay for health expenses out of pocket during their working years to let their HSAs grow tax-free and then begin making tax-free withdrawals in retirement. 

(Be aware of the rules surrounding Medicare and HSAs as you approach age 65.)  

529 Plans (36:47)

Given that funding children’s higher education is a top priority for many, it’s essential to highlight Section 529 plans. There are two types of 529 plans: prepaid tuition plans and college savings plans. We typically recommend the latter, so that will be our focus today. College savings plans offer tax-deferred growth and tax-free withdrawals for qualified educational expenses. The list of qualified expenses is broad, covering room and board, tuition, books, and more. While each state typically offers its own 529 plan, you are not limited to choosing your home state’s plan. You might miss out on a small state tax deduction if you switch, but the potential benefits could far outweigh that drawback. We particularly like Utah’s plan, my529, due to its excellent investment options. 529 plans are an important part of a high-income family’s college plan. 

Managing Equity Compensation (38:50)

Restricted stock units (RSUs) are shares of your employer’s stock granted as part of a broader compensation package. These shares typically follow a vesting schedule, with the fair market value taxed as ordinary income as they vest. An important point with RSUs is ensuring that enough taxes are withheld. The default withholding rate for RSUs is 22%, but this is often insufficient and could result in tax penalties.  

If additional withholding is required, you have two options: 

1. Sell to Cover: A portion of your shares is sold when they vest to cover taxes on the full vested amount. 

1. Quarterly Tax Payments: You can make estimated quarterly tax payments from your cash flow to cover the taxes owed. 

Employer stock purchase plans (ESPPs) allow employees to purchase company stock through payroll deductions, often at a discounted price, with a maximum discount of 15%. Some plans also feature a Lookback Provision, which lets you buy the stock at a lower price between the start or end of the offering period, potentially increasing the discount. If your ESPP includes these provisions and you have the cash flow to support the purchase, participating is generally a smart choice. 

Key considerations for RSUs and ESPPs: 

1. Avoid Holding a Large Amount of Employer Stock: It’s risky to hold a concentrated position in any single stock long term, especially when it’s your employer’s stock. While there is potential for reward, the associated risks are significant. It’s often wiser to sell the stock and reinvest the proceeds in a diversified portfolio. 

1. Accurate Tax Reporting: Ensure that you report the sale of shares accurately on your tax return. Brokerages can sometimes misreport basis, leading to potential double taxation. The correct basis information is usually provided in a supplemental document. 

Efficient Charitable Giving (42:41)

Giving to charity is a meaningful way to share your wealth and support causes you care about. However, it is important that it aligns with your personal goals because charitable giving alone will not improve your financial situation. That said, maximizing the tax benefits of charitable donations can help you keep more of your money—whether it be for personal use, passing on to heirs, or funding future charitable gifts. 

One effective strategy is to batch multiple years’ worth of donations into one larger gift. Here’s why this approach can be more beneficial than spreading your donations out over time: 

Recent tax legislation significantly increased the standard deduction—the amount you can automatically deduct from your income when filing taxes. In the past, charitable donations were commonly included as itemized deductions. With the higher standard deduction, many people now give to charity without receiving any financial benefit. By grouping several years’ worth of donations into a single year, you may be able to surpass the standard deduction and reduce your taxes.  

An excellent option to batch donations is by using a donor-advised fund (DAF). A DAF allows you to make larger donations and then distribute those funds to various charities over time. While donors do relinquish control over the assets, they retain the ability to name organizations to which future grants should go. 

An ideal source of funds for a DAF donation is appreciated securities. Donating these allows you to claim a deduction for the full fair market value of the asset in the year of the donation without triggering any capital gains tax from a sale or disrupting your cash flow. The DAF can then sell the securities to make donations or reinvest the proceeds to continue growing. 

Taxable Brokerage Accounts (45:56)

The final set of strategies we’ll discuss focuses on taxable brokerage accounts. While these accounts don’t offer the same tax benefits as retirement accounts—such as tax deductions or deferral—they do provide a few unique advantages. For example, they aren’t subject to contribution limits, RMDs, or income-based restrictions. You can deposit and withdraw as much as you like. Additionally, income from taxable brokerage accounts may qualify for preferential long-term capital gains rates instead of ordinary income tax rates. Overall, taxable brokerage accounts are excellent for providing flexibility.  

The two strategies I want to highlight with taxable brokerage accounts are tax-loss/capital-gain harvesting and tax location. 

In any diversified portfolio, some positions will perform well in the short term and others may incur losses. If you find yourself with losses, tax-loss harvesting might be worth considering. This involves selling a position, realizing the loss, and reinvesting into a similar but substantially different security. The IRS allows you to use this loss to offset capital gains realized during the year. If your losses exceed your gains, you can use up to $3,000 per year to offset ordinary income, such as earned income from your job. 

Capital-gain harvesting is the reverse. It involves deliberately selling positions with embedded gains to accelerate income. This is often done in years with low income to take advantage of the 0% long-term capital gains tax bracket. 

Lastly, we have tax location, which refers to strategically placing investments in accounts that maximize a portfolio’s tax efficiency. For example, if your portfolio includes pretax, Roth, and taxable brokerage accounts, you should allocate the highest expected return assets, such as riskier stocks, to the Roth account, lower-return assets like bonds to the pretax traditional account, and the most tax-efficient assets to the taxable brokerage account. For larger portfolios, this kind of thoughtful asset placement can significantly improve tax outcomes.  

Tax planning is a complex task, often making it difficult to know where to begin. With numerous strategies and factors to consider, determining which approach is best for you requires thorough research and time. This is where an experienced, credentialed financial planner can provide invaluable guidance. If you believe you could benefit from assistance in navigating the complexities of your finances, please reach out to our team.