Help with tax deferral strategies

[anonymous_fred]

Hello,

I'm new here, and am interested in picking everyone's brain on investing ideas for relatively affluent younger people. My wife and I are both in our early 30s, and would like to be able to retire by age 40 (we don't have immediate plans to retire at that age; we would just like to have the option).

We pay a marginal tax rate of about 42% for state + federal taxes. We max out our 401Ks, and do not qualify for IRA contributions. We save around $100K per year: $30K inside our 401ks and $70k in taxable accounts.

Obviously we are getting reamed on taxes, such that the $70k in taxable savings ends up costing us somewhere around $110k. Our taxable savings are invested in relatively tax efficient index funds (Vanguard Target Retirement).

I'm interested in any other tax deferral strategies aside from the 401k. Any ideas? I've looked a little into annuities, but they seem fraught with sketchy sales pitches. The non-qualified to Roth IRA rollover is enticing (though not really a tax deferral strategy), but I'm not confident that loophole will remain open after 2008.

 

[lswswein]

No magic bullets for avoiding taxes. Just keep investing in Index funds with low tax impact and in you like add more to the Tax managed funds at Vanguard.

-h

 

[Peaceful_Warrior]

Though heavily frowned upon here, you could look into some cash whole life insurance policies with dividend-reinvestment. If you are interested, I would recommend you do a **LOT** of research into this topic first so you don't get reamed into buying the wrong product. WL is a very misunderstood product that can fit into some peoples' portfolios quite well (and is a disaster for some peoples' portfolios).

A basic cash whole life policy that pays and compounds dividends is historically a better investment than low-risk bonds. I remember reading that from a reliable source, but cannot cite it right now (though you'll probably come across it during any research you may do).

 

[Olav23]

Unfortunately, the target retirement funds (depending on what year you choose) are not that tax-efficient due to the bond component. And, as it gets closer to the target date, it sells off equities and adds more to the bond component, generating capital gains as well.

I would buy the equity portions as separate index funds in your taxable accounts, and the fixed income side in your 401k. Sure, it isn't as simple as just buying one fund, but you'll save on the tax-bite.

Since you are already at Vanguard, I'd look into their tax-managed funds or total market for the taxable. Then, buy a bond fund or 2 in your 401k to your target allocation.

 

[LOL!]

Olav23 is absolutely right. Target retirement funds are not tax efficient. Even balanced funds are not tax efficient.

I have recently switched my 401k to be allocated 90% to a bond fund. I have switched my taxable balanced fund to be a tax-managed international fund, a small cap ETF and an international ETF. The equivalent of the fixed income portion of that balanced fund was moved from an international fund in my 401k to the bond fund in my 401k and to a bond fund in a 529 plan. I end up with the same asset allocation, but I now do not get several thousand dollars in taxable income from that balanced fund.

That saves a bundle on taxes without affecting my early retirement plans at all. Basically, you should be able to reduce your Schedule B and D income to about 1% to 2% of taxable investments from the dividends they spin off. And those should be qualified dividends taxed at a lower rate.

If your tax-deferred plans cannnot hold all the tax inefficient assets like fixed income, REITs, etc. Then consider putting these in 529 plans if you have kids (it's unorthodox, but it works). After that, you have tax-free muni bond fund to considers.

 

[MooreBonds]

Hello,

I'm new here, and am interested in picking everyone's brain on investing ideas for relatively affluent younger people.

Depending on what health insurance plan you have at work (and whether you're interested in possibly getting your own family plan outside of work), a Health Savings Account (HSA) would be a great addition to your investment stash.

Basically, an HSA is the greatest savings opportunity for a majority of high earners (as well as everyone else). All you need is relatively good health, a high deductible health plan, and a couple can sock away as much as $5,100 +/- a year. Not only is that $5,100 deductible off of your taxes, but the earnings will be tax free as long as you use it for health care expenses (so it has the tax deductibility of a 401(k), AND the tax-free forever attributes of a ROTH). If you don't spend all of it for health care expenses when you turn 65, you can withdraw it and simply pay income tax on it (as though it were a 401(k) ).

So, worst-case scenario: it's another way for an affluent couple to sock away another $5,100/year tax-deferred. Best-case scenario: you don't pay income taxes on it and the earnings are tax-free!

Do a search for "HSA" on the forum. There have been a few threads on it. Feel free to PM me with any questions.

--Peter

 

[FinanceDude]

I'd go with tax-managed funds. Also, do you have AMT exposure? You might want to look at non-AMT muni bond funds for the fixed income portion of your portfolio.

You can search "annuity" on here for MANY LONG discussions on the topic. However, I will mention that mighty Vanguard themselves offer annuities, so take that for what it's worth.............

 

[ziggy29]

There isn't much in the way of tax-deferred options for you. You can try to minimize taxes, though. In taxable brokerage accounts you might replace the target fund (if you're comfortable with that allocation) with a combination of a tax-efficient equity fund and perhaps a muni bond fund (tax free in your state if available). With the muni bonds, though, you could get nailed by the AMT so be careful on that one.

Long-term holding of dividend stocks (or perhaps an ETF like DVY) is another option as long as tax rates are capped at 15%. That's not "deferral" of taxes but it's at least paying preferred tax rates.

 

[anonymous_fred]

Thanks all for the great suggestions.

I'll have to look more into the tax implications of the TR fund -- my assumption has been that since these funds are comprised of index funds, there should be relatively little turnover, and any adjustments to the allocation will be done in small increments over a long period of time. I have been reluctant to invest in the component aspects of the TR fund on my own (which would allow more tax-efficient splitting across taxable and tax-deferred accounts) because I'm worried that my own rebalancing will be less efficient than Vanguard's.

I have generally avoided municipal bonds because my state (Oregon) has a relatively illiquid Muni bond market and a high tax rate (9%). So I generally am stuck paying state tax anyway, which lessens the benefit of the muni bond.

The HSA is a great vehicle. I forgot to mention that both my wife and I participate in an HSA; in fact I generally pay our deductibles out of pocket rather than from the HSA, to increase the HSA balance. I do have concerns about "nickle and diming" ourselves with small accounts, even if those accounts have great tax benefits, but that's a topic for another post

We do usually pay AMT, because of our high state tax rate. I haven't yet fully understood how or whether that affects which investments are most appropriate for us though, as mentioned above, I do understand that some muni bonds are treated differently for AMT purposes...

Thanks everyone!

 

[FinanceDude]

Thanks all for the great suggestions.

I'll have to look more into the tax implications of the TR fund -- my assumption has been that since these funds are comprised of index funds, there should be relatively little turnover, and any adjustments to the allocation will be done in small increments over a long period of time. I have been reluctant to invest in the component aspects of the TR fund on my own (which would allow more tax-efficient splitting across taxable and tax-deferred accounts) because I'm worried that my own rebalancing will be less efficient than Vanguard's.

I have generally avoided municipal bonds because my state (Oregon) has a relatively illiquid Muni bond market and a high tax rate (9%). So I generally am stuck paying state tax anyway, which lessens the benefit of the muni bond.

The HSA is a great vehicle. I forgot to mention that both my wife and I participate in an HSA; in fact I generally pay our deductibles out of pocket rather than from the HSA, to increase the HSA balance. I do have concerns about "nickle and diming" ourselves with small accounts, even if those accounts have great tax benefits, but that's a topic for another post

We do usually pay AMT, because of our high state tax rate. I haven't yet fully understood how or whether that affects which investments are most appropriate for us though, as mentioned above, I do understand that some muni bonds are treated differently for AMT purposes...
Thanks everyone!

There ARE muni funds that either invest entirely in non-AMT issues, or keep it to a low percentage.

IMHO, I don't use the muni bond funds as much that are state specific. In a LOT of cases, you get a bunch of illiquid uninsured and/or unrated issues in there. I am more concerned with AMT exposure and finding ways to reduce the FEDERAL tax rate............

 

[MooreBonds]

Hello,

We pay a marginal tax rate of about 42% for state + federal taxes. We max out our 401Ks, and do not qualify for IRA contributions.
...
I'm interested in any other tax deferral strategies aside from the 401k. Any ideas? I've looked a little into annuities, but they seem fraught with sketchy sales pitches. The non-qualified to Roth IRA rollover is enticing (though not really a tax deferral strategy), but I'm not confident that loophole will remain open after 2008.

I'm unclear based on what you said above...but although your income doesn't allow you to contribute to a ROTH IRA, and your Traditional IRA contributions aren't tax-deductible, you should still be able to make non-qualified contributions to a traditional IRA (to benefit from tax-deferred compounding). Didn't know if your reference to "non-qualified to Roth IRA" referenced that, or something else.

 

[anonymous_fred]

I'm unclear based on what you said above...but although your income doesn't allow you to contribute to a ROTH IRA, and your Traditional IRA contributions aren't tax-deductible, you should still be able to make non-qualified contributions to a traditional IRA (to benefit from tax-deferred compounding). Didn't know if your reference to "non-qualified to Roth IRA" referenced that, or something else.

I'm not a big fan of non-deductible IRA contributions. It's true you get tax deferred compounding, but the tax you pay eventually is regular income tax rather than lower capital gains and dividend tax. Generally even a moderately tax efficient fund will beat a non-deductible IRA contribution hands down. And the non-deductible IRA has the additional drawback of locking your money up for a long time.

However there's a provision in last year's pension reform act (I think that's where it originated...) that, starting in 2010, lets individuals make traditional IRA to Roth IRA rollovers regardless of income level. That means that a high income earner could make a non-deductible traditional IRA contribution now, then in a few years roll that over to a Roth IRA where it can grow without any further taxation.

But there are rumblings that this loophole will be closed. So I'm not inclined to make contributions now with the hope of rolling them over later, because I really don't want to be stuck with money locked in a traditional IRA, for which I'll never receive tax benefits!

 

[melloA]

I think non-deductible IRA contribution is still fine. IRS will allow 2010 converstion from IRA to Roth without income limit and tax deferred to 2011 and 2012. Even if they eventually close off that particular loophole, that will still allow you additional tax saving on assets transferred to Roth.

 

[anonymous_fred]

I think non-deductible IRA contribution is still fine. IRS will allow 2010 converstion from IRA to Roth without income limit and tax deferred to 2011 and 2012. Even if they eventually close off that particular loophole, that will still allow you additional tax saving on assets transferred to Roth.

I have heard rumblings that this loophole may be closed before anyone gets to use it. Many of the presidential candidates have explicitly stated that they will reverse most of the recent tax changes that benefit the successful.

*If* that happens, any contributions to the traditional IRA will *not* be able to be rolled into the Roth if one exceeds the income limit, and will be stuck in the traditional IRA until withdrawals can begin.


Fred

 

[jIMOh]

I'd reiterate it's OK to have a tax problem. It's better to have a tax problem than an income problem.

On with the countdown...

I would move out of target retirement funds (in taxable accounts) and use a total market index fund. The taxes you pay on this will be minimal now, and when you sell this, it would be taxes at lower capital gains rates.

A second possibility is to invest in individual stocks.

In either case, getting here does cause a tax problem though, because I assume you have somewhere between 100k-500k in a taxable account invested in a target fund. Here are steps I would take to minimize the tax hit

1) do not reinvest dividends
2) sell shares in "lots", trying to sell some lots at a loss of offset gains in other lots.
3) over time the "non reinvestment" of dividends and distributions should minimize taxes paid over time.

 

[FinanceDude]

1) do not reinvest dividends
2) sell shares in "lots", trying to sell some lots at a loss of offset gains in other lots.
3) over time the "non reinvestment" of dividends and distributions should minimize taxes paid over time.

Most CFP's I know already recommend this, and FPA has run some workshops about taking dividends instead of reinvesting............

 

[anonymous_fred]

I would move out of target retirement funds (in taxable accounts) and use a total market index fund. The taxes you pay on this will be minimal now, and when you sell this, it would be taxes at lower capital gains rates.

I'm curious about this -- I'm using the TR fund because of its low expenses; I'm in Vanguard's TR 2035 fund which is allocated:
71.9% Vanguard Total Stock Market Index
10.5% Vanguard European Stock Index
10.1% Vanguard Total Bond Market Index
4.7% Vanguard Pacific Stock Index
2.8% Vanguard Emerging Markets Stock Index

So the fund is already largely invested in total market indexes, with only 10% in a total bond component. If I switched completely to a TSMI fund, I would need to get my bond component elsewhere.

Most CFP's I know already recommend this, and FPA has run some workshops about taking dividends instead of reinvesting............

Can you expound on this? I assume this means *if* one is drawing down his taxable account, it is better to do so by taking dividends (which are already taxed) than reinvesting the dividends, and selling shares (at which point taxes are due on both the dividends, which were reinvested, and on the capital gain).

But at this point I'm still adding to this fund. Optimistically I won't start drawing it down for another 10 years. Is there a reason not to reinvest in the interim?



Thanks!
Fred

 

[jIMOh]

I'm curious about this -- I'm using the TR fund because of its low expenses; I'm in Vanguard's TR 2035 fund which is allocated:
71.9% Vanguard Total Stock Market Index
10.5% Vanguard European Stock Index
10.1% Vanguard Total Bond Market Index
4.7% Vanguard Pacific Stock Index
2.8% Vanguard Emerging Markets Stock Index

So the fund is already largely invested in total market indexes, with only 10% in a total bond component. If I switched completely to a TSMI fund, I would need to get my bond component elsewhere.



Can you expound on this? I assume this means *if* one is drawing down his taxable account, it is better to do so by taking dividends (which are already taxed) than reinvesting the dividends, and selling shares (at which point taxes are due on both the dividends, which were reinvested, and on the capital gain).

But at this point I'm still adding to this fund. Optimistically I won't start drawing it down for another 10 years. Is there a reason not to reinvest in the interim?



Thanks!
Fred

whatever tax situation you have now with TR 2035 fund, the tax situation will get worse before it gets better. The bond position will grow, and the equity positions sold.. creating the whammy of capital gains+interest from bonds.

Compounding will compound the problem next year (and the year after...)

step 1 is to cut off the compounding. Stop reinvesting dividends in a tax inefficient asset.

step 2 is to redeploy the cash (from dividends) into something more tax efficient (I suggest total market index).

step 3 is to do some research on asset allocation (maybe this should be step 1). You are seeing trees, but don't realize you are in a forest. Look at your whole investment picture and come up with a plan.

And do not let the tax tail wag the investment dog/ asset allocation dog. Paying taxes is not a bad thing. Minimizing taxes yes, but if you try to avoid taxes, you might hurt your return.

Look for tax efficiency (such as owning individual stocks) and tax rates for a) capital gains and b) dividends.