By Matthew McKee, CFA, CFP®
September 1, 2022
Financial planning that focuses on your goals and helps you achieve flexibility in your journey is critical at the mid-point of your career. It’s how you build a plan to help you realize the lifestyle you want now while keeping longer-term achievements on track. Staying on top of your career earnings by regularly benchmarking your salary to the market and effectively managing equity compensation are two areas where you can keep the income element growing and your wealth building. But an overlooked area is how much of your income you get to keep.
As income increases, it becomes even more essential to ensure that you are optimizing your tax planning. And a good tax plan doesn’t just happen in April every year. Proactive planning during the year, and a strategic plan that takes a multi-year view, can make a big difference in keeping your lifetime taxes as low as possible.
Moves you make now can also set you up for more income potential and greater tax efficiency in retirement. If an early retirement, work-optional, or one spouse temporarily or permanently leaving the workforce is a goal, focusing on effective tax planning can get you there sooner. When you put all the plan elements in play, you can create a lot of optionalities.
Tax-Advantaged Savings and Investing Vehicles
Ensuring that you are maximizing tax-advantaged savings tools is at the top of the list regarding tax planning. Putting away money in tax-deferred accounts reduces your income in the year you contribute. Taxes on the original contribution and growth are due when the funds are withdrawn in retirement.
Contributing the maximum amount to a 401(k) of $20,500 in 2022 (plus the catch-up amount of $6,500 for those 50+) may have an additional benefit this year. Asset values are lower, so your contribution will have more purchasing power. Keep contributions steady and spread out, so you can minimize the impact of any further declines.
You’ll need to wait until age 59 ½ to access the funds, or there will be a penalty on withdrawals, in addition to taxes. You want to be sure you set yourself up to have income flexibility in retirement, so when you eventually pay the taxes, you’ll be in a lower tax bracket.
If one spouse is no longer working, don’t neglect retirement savings in a spousal IRA. This is a regular IRA account in the non-working spouse’s name. It circumvents the IRS rule that you must have income to contribute to an IRA. The amount that can be deducted depends on whether the working spouse has a 401k plan. For 2022, an income of $204,000 or less means that the full amount of the spousal IRA contribution is tax-deductible.
A Healthcare Savings Account (HSA) is a tax-advantaged way to put money away in an investment account for health-related spending in retirement. Qualified spending isn’t just on doctor visits or medical needs – it also includes long-term care policy premiums, so starting an account now is a great way to cover these premiums later.
HSAs are triple-tax-advantaged. This means that money you put away reduces income in the year of the contribution – in 2022, that’s $3,650 for self-only and $7,000 for families, plus $1,000 catch up for those over 50. The money grows tax-free, and qualified withdrawals are also tax-free.
The HSA requires a high-deductible health insurance plan, so you’ll need to review your coverage needs and ensure your plan meets the criteria.
Savings in a 529 plan grow tax-free, and qualified withdrawals are also tax-free. Funding them with up to $16,000 annually keeps the amounts under the gift-tax exemption, so no taxes are due. In addition, some states provide tax benefits for contributing to a 529 plan.
Keep in mind – these aren’t just for college anymore. The fund can be used for K-12 education as well. The tax-free growth lets you get ahead on education saving. Like any investment, as you get closer to the date when funds will be needed, you want to adjust your investment mix for lower risk.
For many families, giving and service are part of their family tradition. By setting up a donor-advised fund, you can receive the tax credit in the year the contribution to the fund is made. But a key advantage is that the funds can be invested and grow inside the donor-advised fund. You can also select investments that reflect your values. You’ll have time as a family to decide what is most meaningful to you and when you want funds to transfer to the charities you choose. This is a terrific way to involve your kids in your family’s giving and also to teach them about investing and the responsibility of donating.
Where You Save Is as Important as How Much You Save
Planning for long-term tax savings means utilizing different types of investment accounts. At this point in your financial journey, you may already have the three main account types:
- Roth 401(k) or IRA set up earlier in career when income was lower
- Traditional 401(k) or IRA
- Taxable Brokerage Account
Having all three accounts means you can match the investment profile to the taxable status of the account. The value is in holding your least tax-efficient investments in your tax-deferred accounts, where you won’t pay taxes. Taxable accounts should hold more tax-efficient investments.
The Way You Invest Matters, Too
Your investment plan should be built around two primary factors: your goals and your risk tolerance. Those are unique and specific to you, and whether you manage your investments yourself or work with an advisor, you’ll need a plan that can keep you on track.
A long-term plan is best achieved by carefully researching and selecting the investments that match your risk tolerance and return profile – and then holding them for at least a year. This is the most tax-efficient, as capital gains on long-term investments held for at least a year are taxed at the much lower long-term capital gains rate. The short-term capital gains rate is much higher and will add to your tax bill – which of course, means reducing the income you have available to invest.
Tax-Loss Harvesting Reduces Taxes – and is Part of a Diversification Strategy
Deploying your taxable accounts to good use means offsetting capital gains with losses. Active planning as you rebalance your portfolio can help you keep your asset allocation in line with your risk tolerance and can save you money as you swap out investments that have appreciated.
A solid tax-loss harvesting strategy can be a key feature of your diversification strategy if you have equity compensation. While employee stock purchase plans, restricted stock units, and stock options can be a powerful way to build wealth, they can also result in overconcentration in your company’s stock. Selling can create big tax bills. Tax-loss harvesting can help. When determining your concentration, if you intend to stay with your company for some time, don’t forget about unvested options.
The Bottom Line
Financial planning used to be something that people did at retirement to convert their savings into income. But lifestyles look different now, and the retirement trajectory is much shorter for many people. Starting early on your financial plan makes sense, and tax planning is a big part of building wealth that will last.
The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation. This work is powered by Advisor I/O under the Terms of Service and may be a derivative of the original. This content not reviewed by FINRA.