Updated September 1, 2015
Have you seen the simplified 1040? It looks like this:
How much money did you make last year? ________________
Send it in ________________
No place for special exemptions, special deductions, credits or other fancy footwork.
In the real world, with the real 1040, there are plenty of special opportunities to save on income taxes. Lobbyists spend every waking hour and no little expense to persuade Congress that their special interest group members deserve special consideration when April 15th rolls around. The resulting special tax advantages can be very valuable, but they are, well… special, and not available to everyone.
On the other hand, everyone has potential opportunities for tax savings via careful transaction timing. Fundamentally, our tax system is progressive – the tax rate on the next dollar of income (the marginal tax rate) is higher for higher incomes. Reduce your income, and pay a lower tax rate. Or, pay your taxes later, and earn interest on the money until you pay them1. So, in general, tax-reducing tips focus on accelerating deductible expenses and deferring income.
If you belong to a special interest group, you probably already know how to take full tax advantage. If you have an accountant, you are likely well-advised on how to manage your income and expenses to best advantage. In either event, you can still benefit from what you’ll read in this article.
This article has a long-term focus. I’ll highlight tax strategies that will keep your taxes down permanently, and raise your after-tax spending power significantly. They are the tax strategy counterpart to “buy and hold” index investing.
You may find it useful to think about your finances over your lifetime as a car taking a long trip. Taxes are a drag! Income and expense timing are comparable to putting new tires on the car, aligning the front-end, getting a tune-up, and having the car detailed. Every one of these steps will improve the car’s mileage and performance somewhat, but not one changes the car’s aerodynamics in any fundamental way. Next year or in 10,000 miles, you’ll have to do the same things all over again. [If you are, or are not, in a special interest group, there’s not much you can do about it.]
Now consider redesigning the car to make it more aerodynamically sleek. Imagine reshaping a Model T (the original box on wheels!) into a Porsche. Even if the two cars had the same engine, the one with the Porsche body would outperform the Model T dramatically. Less drag! Completely redesigning a car is hard – witness the 70 years or so to it took the boxy Ford Model T to evolve to the sleek Porsche 911. Only an engineer can understand (let alone love!) the many incremental steps it took to get there. Nevertheless, the result of all of those incremental steps is an enormous [and permanent] increase in miles per gallon due to (among other things) reduced drag.
It’s somewhat the same with your taxes – organizing your finances for long-term tax efficiency requires taking a number of steps, some of them time-consuming. However, when you are finished you’ll have a financial structure with much less tax drag, year in and year out. Just as the Porsche slips smoothly through the air, you won’t notice or measure the daily impact of each component of the structure – you don’t have to save taxes you don’t owe!
The suggestions you’ll find in this article are of the second kind – intended to change the arrangement of your financial resources to minimize the burden of taxes year in and year out. You can make these changes any time, but now is always the best time. The sooner you establish a streamlined financial structure, the longer you’ll have to enjoy it (and the more after-tax spending power you’ll have).
Establish a Streamlined Financial Structure (Tax-wise)
Your financial structure consists of accounts – locations to hold assets and locations you owe money (debts or liabilities) – and the assets and liabilities themselves.
Only some accounts have tax advantages. The first step toward long-term tax efficiency is to be sure that you are using all of the tax-advantaged accounts available (and useful) to you. Tax-advantaged credit or debt accounts and tax-advantaged asset accounts are both available.
Your mortgage and home equity line of credit are the most obvious tax-advantaged credits. Interest on these loans is tax-deductible2. In addition, interest rates on home mortgages tend to be lower than car loans or credit card loans. As a result, the after-tax rate of interest you pay on a mortgage loan is likely to be a lot lower than the rate you’d pay on a car or credit card loan.
For example, suppose you have a mortgage at 6%, a $20,000 car loan at 8%, and $5,000 in credit card loans at 12%. Let’s assume you are in a 40% state plus Federal marginal income tax bracket (that is, the IRS and your friendly state and local tax authorities tax your next dollar of income at 40%). Your annual after-tax savings from shifting your borrowing to your mortgage would be $1300 per year, or nearly 60% of the $2200 interest you’d pay otherwise.
The after-tax interest rate on your mortgage is 3.6%, while the after-tax rate on the car is 8% (no tax benefit). That 4.4% difference is worth $880 per year to you. The after-tax rate on the credit card is 12% (no tax benefit there, either), so the 8.4% difference is worth $420. Adding $25,000 to your mortgage and paying off the car and credit card loans with the proceeds would save $1300 per year.
Strictly speaking, this saving is due both to lowering the interest rate you pay, and to the tax-advantaged nature of the (low interest) mortgage loan (see table). However, even if the car loan and the credit card loan were both at only 6% pre-tax (the same as the mortgage), you’d still get a $600 (40%) refund on the $1500 interest bill for the car and credit card.
By the way, car leases involve interest, too, even though car dealers are reluctant to emphasize the point. So – pay cash for your car, pay off your credit card each month, and save a lot on taxes (and interest).
Are there drawbacks to this strategy? There are at least three:
- Credit card debt is unsecured; only your car secures car loans. Defaulting on credit card debt poses a risk to your credit rating, defaulting on a car loan will cause repossession of your car. Default on your mortgage loan or home equity loan risks loss of your home. This is a risk each family must assess and decide for itself.
- High-income families will receive a smaller tax benefit. The tax deduction for mortgage interest (and other itemized deductions) begins to phase out for (adjusted gross) incomes above $142,700. The deduction declines by 3% of AGI above $142,700, with a maximum decline of 80%. For higher incomes, in other words, the deduction is (much) smaller, and the benefit of consolidating car and credit card debt into a mortgage or home equity line of credit is limited.
- Consolidating a credit card loan into your mortgage increases your ability to borrow on that card. It’s important to have an effective strategy for keeping your credit card debt at zero3.
Asset accounts targeted at retirement and higher education offer valuable tax benefits. You can increase your family’s spending power by taking full advantage of each, to the extent they are relevant and appropriate for you.
The sheer number and variety of tax-advantaged retirement accounts is bewildering. There are individual plans (such as regular and Roth IRAs) and employer sponsored plans (such as 401(k)s and 403(b)s). There are even hybrids of the two – you might call these employer-sponsored individual plans (such as SEP IRAs and SIMPLE 401(k)s). This article will not review the merits and demerits of each one, nor attempt to help you determine which one or ones might be right for you. We’ll have to leave that for another article.
Once you’ve identified your retirement plan of choice, you must be sure to do five things:
- Establish the account in time to realize a benefit this year. You can establish some accounts (such as traditional and Roth IRAs) until the due date for taxes for the year in question – April 15, 2007 for 2006. You must establish others much earlier – for example, a SIMPLE IRA must be established by October 1st, while individual 401(k) plans must be established by December 31st or the business fiscal year end. You have to have an account in order to contribute to it.
- Contribute to your accounts. Having a retirement account will produce a tax benefit only if you contribute to it. The tax benefit is a higher after tax rate of return on any investment in the account. The advantage depends upon the pre-tax rate of return on your investment, and the number of years you have to gain the tax advantage. The table at right illustrates (assuming a 40% tax rate). The tax benefit is larger for higher rates of return. For example, at ten years, the tax benefit is $20 per $1,000 invested at a 4% rate of return, and nearly $100 at 8%. The tax benefit is larger for longer holding periods. For a 6% rate of return, the tax benefit is $554 per $1000 for 25 years, and nearly twice that if you can hold the asset in the tax advantaged account for 30 years. Note: These benefit estimates assume that investments in both taxable and tax-deferred accounts are in fixed income assets (bonds). The benefits may be smaller for equity investments (see the discussion of asset location below).
- Contribute enough to receive matching contributions from your employer if your employer’s plan offers them. Like the lower interest rates on home mortgages, employer-matching contributions are a benefit associated with a tax-advantaged account that is not a tax benefit, strictly speaking. However, these benefits are extremely valuable4. 100% matches represent 100% returns on your money, 50% matches are 50% returns, etc. Alternatively, you can think of employer matching as a raise you don’t even have to ask for. Choose the description you find most motivating, and act on it.
- Contribute early in the year. We just saw that the tax benefit is larger for longer holding periods. If those holding periods are long enough, the advantage of just one more year is very large – and one more year is what you get by contributing on January 1st rather than December 31st (you get more than a year by contributing January 1st rather than April 15th of the following year). The table at right shows the additional tax benefit of contributing early in the year. If you can expect your holding period to be at least 20 years, the incremental benefit goes from $14 to $100 as the rate of return ranges from 4% to 8%. Even if you are 65, and ready to retire, chances are very good you may not draw on the money for 20 years – there’s still good reason to contribute early in the year.
- Take your required minimum distributions. Rules for distributions from retirement plans are very strict, and the penalties for breaking them are draconian. The rules are also extremely complex – when it’s time to start to take distributions, you may find it worthwhile to seek guidance from a professional specializing in this area5. By law, distributions from most retirement plans (Roth IRAs are the major exception) must begin in the year after you turn 70½. The IRS has promulgated tables of minimal distribution rates. Failure to meet the requirements results in penalties of 50% (half!) of the shortfall from the required distributions. That could ruin your whole day – not to mention its negative impact on your net tax benefit.
There are several potential drawbacks to tax-deferred retirement savings:
- You can save too much. In this case, you don’t spend as much as you could when you are young, and find yourself being able to increase your standard of living dramatically when you retire. At that point, it’s too late to go back and take the vacations you missed, and buy the car you had wanted to buy. Another risk of saving too much is discovering that you need to take distributions before 59½ (the earliest allowable date in most cases). Such early distributions involve tax penalties of 10% – again reducing your tax benefit. You can overcome these risks, but it’s hard work. Better to set your savings target correctly in the first place.
- You can save in a low tax bracket, only to withdraw in a high tax bracket. If you expect a big inheritance or if you expect tax rates to rise a lot in a short period of time, your tax rate may be higher after you retire than when you are contributing. This will reduce the size of your tax benefit, but unless the time horizon is short (say 5 years or less), the benefits are still positive. This is not an issue in the case of Roth IRAs – you owe no taxes on those distributions.
- You can turn capital gains into ordinary income. Capital gains tax rates are lower than ordinary income tax rates. Ordinary income tax rates apply to distributions from most tax-advantaged retirement accounts (except Roth IRAs). If you plan to invest your retirement contribution in equities that you intend to produce significant capital gains, and if you plan to withdraw the contribution and its returns in a short time (say 5 years or less), then the tax benefits are likely to be small6.
Saving for higher education also offers opportunities for tax benefits. You should consider these opportunities carefully – financial aid reductions may reduce the tax benefits significantly (see my article, “Saving for College,” on Index Investor for a full discussion). Education account tax benefits are usually smaller than retirement account benefits – you save smaller amounts, and you have a shorter time to realize the benefits. On the other hand, you pay no tax (as in zero) on 529 and Coverdell education savings account distributions used for higher education expenses. As a result, if you decide that a tax-advantaged college savings plan is for you, the tax benefits can be very significant. The rules for success are generally the same for education savings accounts as they are for retirement savings accounts.
- Establish the accounts timely. You can set up a Coverdell account for this year by April 15 of next year. However, Federal gift tax rules govern 529 accounts – gifts must be completed (the plan must cash the check!) by the end of the calendar year to qualify for that tax year.
- Contribute to the accounts. Each parent can add up to $12,000 per child per year to these accounts. Moving money to these accounts turns taxable returns into tax-free returns. Larger contributions produce larger tax benefits, as do contributions earlier in your child’s life. Even contributing just one year before you expect to need the money generates tax benefits, however. If you can contribute ten years ahead, even earning only 4% on your investment yields a tax benefit of an extra 21% ($213 per $1000 invested) in spending power.
- Contribute early in the year. Just as with retirement savings, contributing on January 1 rather than December 31 is worth a good deal (and of course, worth even more than waiting until April 15). If you can wait 5 years, the extra benefit [beyond the benefits shown in the previous paragraph] of investing early in the year is $22/$1000 at 4% (an extra 2%). It can be as much as a full $274/$1000 (an extra 27%) for money invested when your child is born, drawn as a last payment for her education, and earning 8% in the interim.
- Don’t contribute too much. A 10% tax penalty applies to money not used for higher education. That is –ordinary income rates apply to all returns – and an additional 10% penalty is charged. The cost is small, $20-$30 / $1000 invested for a wide range of returns and periods, but there is no need to incur it. The numbers at the lower right corner of the box may tempt you – invest for a long time at a high rate of return, and you make out well even after the tax penalty. Unfortunately, you must close Coverdell and 529 accounts by the time the beneficiary reaches 30, and the contribution constraints limit the usefulness of this “option” (even if the rates of return were attainable with bonds).
- Withdraw according to the rules. The same tax penalties apply to all withdrawals not used for higher education. Errors here can void your entire tax benefit.
Finally, there are tax-advantaged accounts offered by life insurance companies. These come in two main varieties – cash value life insurance and variable annuities. Usually, a commissioned life insurance agent or retail securities broker will bring one or both of these types of products to your attention. That usually means high fees and expenses to cover the commission, and a less-than-objective view on the benefits.
If you have exhausted all of the tax-saving opportunities available through retirement and educational savings, a product of this type may offer some benefit. Unless the fees and expenses are very low, you will do better with a buy-and-hold index investment strategy for fixed income. If you are considering an equity investment, expenses must be extremely low (and your investment horizon very long) for these products to beat a simple index strategy.
Manage capital gains and losses
In tax-advantaged accounts, you can trade to your heart’s content without affecting your tax advantages. The impact on your returns is likely to be negative, but that’s another story.
In taxable accounts, trading has tax consequences. Taking losses has benefits – you can deduct up to $3,000 of losses from income in any year. Furthermore, you can carry losses forward from one year to the next, and you can use them to offset gains that you realize as you rebalance, if you must.
Taking gains has costs – capital gains taxes must be paid now rather than (much) later. The benefits of tax deferral are lost.
Therefore, the trading rules for taxable accounts are very simple:
- Take your losses every year.
- Rebalance only when you must to maintain your target asset allocation.
- Don’t trade otherwise. (Taking gains forces you to pay taxes rather than defer them, reducing your lifetime after-tax returns).
Allocate your assets to maximize tax advantages
Once you’ve established a streamlined account structure, and you’ve contributed assets to all of the accounts you’ve set up, the next question is how to invest the assets. Your choices here can have a significant influence on the spending power you realize during your life, beyond the return you earn on each investment.
Your first investment decision is asset allocation – how much to stocks (and which kinds of stocks), how much to bonds (and which kinds) and how much to cash. (Stocks, bonds and cash are asset classes.) This decision is also beyond the scope of this article. IndexInvestor.com offers sophisticated asset allocation advice, and so do many investment advisors.
Once you have an asset allocation, your next decision is asset location – assigning asset classes to accounts. You should plan your asset location to produce the largest possible after-tax rate of return on your entire portfolio. The basic rules are simple:
- Line up your asset classes from most to least susceptible to tax advantage.
- Place the most susceptible in the tax-advantaged accounts (retirement and college savings) first.
- Then place the next asset in the tax-advantaged accounts.
- Continue until you’ve used up all of the capacity in your tax-advantaged accounts.
Ranking the assets on susceptibility to tax advantage depends on a number of factors – time horizon, return assumptions, your tax rates, and your trading tendencies to name just the most important. The following ranking rules are good rules of thumb:
- Commercial real estate is most susceptible to tax advantage (its dividends count as interest).
- Higher yielding bonds are next.
- Higher risk and return equities are next (emerging markets and small cap stocks are good examples), with special advantage to high dividend asset classes.
- Ordinary equities follow – still susceptible to tax advantage, but less so than the asset classes above.
- Cash and low yielding bonds are last – highly susceptible to tax advantage in percentage terms, but the returns are so low that the dollar impact is minimal.
Let me emphasize, however, that these are just rules of thumb. The most tax-advantaged allocation will depend upon the likely returns for each asset class, the nature of your tax deferral opportunities, your self-discipline in terms of taking capital gains, and your time horizon.
The following table illustrates the analysis that forms the basis of the rules of thumb: the table indicates the dollar value at the end of a 30-year investment horizon of $1000 invested in each of two asset classes. For example, $1,000 after-tax dollars invested in each of equities and REITs would produce 7% more if the REITs are sheltered in a 401(k) than if the equities are sheltered. Bold type highlights the better decision. Note that the nature of the tax sheltered investment matters a great deal. Variable annuities (VAs) and non-deductible IRAs produce very different results than 401(k)s and Roth IRAs because the tax advantages are smaller, and in the case of VAs, expenses are higher.
The assumptions matter. For example, slightly higher fixed income interest rates reverse the preferred allocation of equity and fixed income investments in 401(k)s. For the table, the assumptions are:
- Pre- and post-retirement ordinary income tax rates both 40%
- Capital gains and dividend tax rates both 15%
- 30 year investment horizon
- Account types: VA – variable annuity, ND IRA – non-deductible IRA
- VA mortality and expense ratio – 100 bps
- Rates of return:
You can see that in some cases the location decision doesn’t matter much, and in other cases it matters a lot. For larger asset bases, the percentages translate into more dollars, and it’s worth more to get the asset location decision right.
- Streamlining your financial structure, and maximizing your after-tax spending power once your brilliant investment strategy has succeeded is conceptually very simple:
- Use your tax-advantaged borrowing power in preference to other forms of borrowing.
- Maximize your tax-advantaged saving opportunities: retirement first, then education.
- Set up the accounts
- Contribute to the accounts
- Contribute early in the year
- Follow the withdrawal rules to avoid tax penalties
- Trade in your taxable accounts only to realize losses and to rebalance.
- Locate your assets to maximize the tax-deferral benefits.
- Tax-deferral benefits can be quite significant. After-tax returns in tax-deferred accounts can be more than double those in taxable accounts.
- There are only a few practical difficulties:
- Planning and self-discipline are essential.
- Assessing asset location benefits can be complex, and may require professional advice.