Preparing a strategy that is both advantageous and tax-efficient might feel daunting at first. Thankfully, there are a few strategies that, if implemented correctly, can provide relief to an unnecessary tax bill.
Backdoor Roth IRA
If you are a high earner with an income above the IRS’s income limit for Roth IRAs, you still have the option to create a backdoor Roth IRA. Just as it sounds, this option allows high earners to bypass the income limits and still utilize the tax advantages of a Roth IRA account.
To open and contribute to a backdoor Roth IRA, there are two simple steps:
- Open and contribute to a traditional IRA.
- Convert your traditional IRA to a Roth IRA.
While a backdoor Roth IRA might not give you the desired tax deduction now if you are in high earning years, it still allows you the opportunity to grow your wealth tax-free if you wait to take qualified distributions in retirement. Additionally, it’s important to remember that Roth IRAs do not have required minimum distributions like Traditional IRAs do. When considering a backdoor Roth IRA, the main factor is the tax obligation you might pay today versus the tax benefits you may realize toward retirement.
While a backdoor Roth IRA has many great benefits, there are two potential pitfalls you will want to watch out for:
First, unless you are over 59.5, it rarely makes sense to withhold taxes from your Traditional IRA. Since most custodians allow you to withhold taxes from the conversion from your Traditional IRA, if you are under 59.5, the amount withheld is considered a premature distribution and is subject to income taxes and a 10% penalty. Instead, consider paying the tax from other money.
Second, be aware of the pro rata rule3. This IRS rule considers all IRA balances you have at the end of the year and can potentially create a tax liability if not handled correctly. If you have a large amount of money in a Traditional, Simple, or SEP IRA, consider this a red flag when considering whether or not to do a backdoor Roth IRA. Working with a knowledgeable advisor can help provide guidance in this area.
Smart moves can help you manage your taxable income and taxable estate. For instance, if you’re making a charitable gift, giving appreciated securities that you have held for at least a year is one choice to consider. In addition to a potential tax deduction for the fair market value of the asset in the year of the donation, the charity may be able to sell the stock later without triggering capital gains.
This discussion of tax-focused giving is for informational purposes only and is not a replacement for real-life advice, so make sure to consult your financial, tax, and legal professionals before modifying your gifting strategy.
The annual gift tax exclusion gives you a way to remove assets from your taxable estate. In 2023, you may give up to $17,000 ($34,000 if you are married) to as many individuals as you wish without paying federal gift tax, so long as your total gifts keep you within the lifetime estate and gift tax exemption of $12.92 million for 2023.1 Managing through the annual gift tax exclusion can involve a complex set of tax rules and regulations. Before adjusting your strategy, make sure to work with a professional who is familiar with the rules and regulations.
Tax-loss harvesting refers to the practice of taking capital losses to help offset the capital gains you may have recognized. Keep in mind that the return and principal value of securities will fluctuate as market conditions change, and past performance is no guarantee of future returns. While this doesn’t get rid of your losses, it can be an approach to managing your tax liability.
Up to $3,000 of capital losses in excess of capital gains can be deducted annually, and any remaining capital losses above that can potentially be carried forward to offset capital gains next year.2 But remember, tax rules are constantly changing, and there is no guarantee that the treatment of capital gains and losses will remain the same in the coming years.
By taking losses this year and carrying over the excess losses into the next, you can potentially offset some (or maybe all) of your capital gains next year. Before moving ahead with a trade, it’s important to understand the role each investment plays in your portfolio.
If you’re looking into this strategy, familiarize yourself with the IRS’s “wash-sale rule.” This rule indicates that investors can’t claim a loss on a security if they buy the same or a “substantially identical” security 30 days before or 30 days after the sale.2
With these strategies in mind, there are things you may be able to do now to address both your current tax obligation and those you may be required to address further down the road.
Proverbs 3:20-22(NLT) states, “My child, don’t lose sight of common sense and discernment. Hang on to them, for they will refresh your soul. They are like jewels on a necklace.” I believe we have to bring this discussion around to the importance of wisdom. Wisdom is the practical application of knowledge to our personal situation. While it is easy to get caught up in the various avenues, techniques, and strategies that we can employ about wealth, it is important to remember that wisdom will lead us into the right choices. We need to continually evaluate the potential benefits of our decisions with the costs associated with implementing them. Many times we don’t see the full picture of what it will take to achieve our desired outcome. Will it involve valuable time away from family? Will it take a large amount of focus away from other things that I am naturally better at? Is it something God is leading me to do?
While ultimately we need to carefully consider our next steps, there is value in exercising wisdom in everything that we do. “Do not forsake wisdom, and she will protect you; love her, and she will watch over you.” Proverbs 4:6(NIV)
Evergreen Financial Group is a Fee-Only Financial Planning and Investment Firm located in Billings, MT serving clients in Montana, Wyoming and virtually across the country. Evergreen Financial Group specializes in working with Christian families, including Young Professionals, Current and Future Retirees and Church Staff Members.
This content is developed from sources believed to be providing accurate information. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security. Evergreen Financial Group, LLC is a registered investment advisor offering advisory services in Montana and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. This communication is for informational purposes only and is not intended as tax, accounting or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement of any company, security, fund, or other securities or non-securities offering. This communication should not be relied upon as the sole factor in an investment making decision. All opinions and estimates constitute Evergreen Financial Group’s judgement as of the date of this communication and are subject to change without notice. Evergreen Financial Group does not warrant that the information will be free from error. The information should not be relied upon for purposes of transacting securities or other investments. Your use of the information is at your sole risk.