8 Strategies for Building a Tax-Efficient Wealth Management Plan

Asset location, also known as asset placement, refers to the strategic allocation of different types of investments across various types of accounts (taxable, tax-deferred, and tax-exempt). The goal is to place assets in accounts where their tax consequences are minimized, thereby maximizing after-tax returns.

Taxable accounts include brokerage accounts, savings accounts, and taxable investment accounts. Investments held in taxable accounts are subject to taxes on dividends, interest income, and capital gains. However, they offer flexibility in terms of accessibility and liquidity. Tax-efficient investments, such as index funds or ETF with low turnover, are often preferred in taxable accounts to minimize taxable distributions.

Examples of tax-deferred accounts include traditional IRAs, 401(k)s, 403(b)s, and other employer-sponsored retirement plans. Contributions to these accounts are made with pre-tax dollars, and investment earnings grow tax-deferred until withdrawal. Withdrawals in retirement are taxed as ordinary income. Tax-inefficient investments, such as bonds or actively managed funds generating high dividends, are typically held in tax-deferred accounts to defer taxes on income and gains until retirement when tax rates may be lower.

Roth IRAs and Roth 401(k)s are examples of tax-exempt accounts. Contributions to Roth accounts are made with after-tax dollars, but qualified withdrawals, including earnings, are tax-free. Since investments in Roth accounts grow tax-free, assets with high growth potential, such as stocks or equity funds, are often favored in Roth accounts.

By strategically allocating assets across these different types of accounts, you can minimize your overall tax burden and maximize after-tax returns. However, your asset location strategy should be tailored to your individual financial goals, tax circumstances, time horizon, and risk tolerance. Also, make sure you periodically review and adjust your asset location strategy as financial circumstances and tax laws change.

Tax-efficient investments are those that are structured or managed in a way that minimizes the tax impact on investors. These investments aim to reduce the amount of taxable income, lower the tax rate applied to that income, or defer taxes until a later date. Here are some common types of tax-efficient investments.

Index funds and exchange-traded funds (ETFs) typically have lower turnover compared to actively managed funds, resulting in fewer capital gains distributions. Since capital gains distributions are taxable, investing in index funds or ETFs can help minimize tax liabilities.

Qualified dividends are a type of dividend income that is taxed at lower capital gains tax rates rather than ordinary income tax rates. To qualify for this favorable tax treatment, a dividend must be paid by a U.S. corporation or a qualified foreign corporation, and the stock on which the dividend is paid must be held for a minimum period. Investing in stocks that pay qualified dividends can be tax-efficient, especially for investors in higher tax brackets.

529 plans are tax-advantaged savings plans designed for education expenses. Contributions to 529 plans grow tax-deferred, and withdrawals for qualified education expenses (such as tuition, room and board, and books) are tax-free at the federal level and often at the state level as well.

HSAs offer triple tax advantages:

• Contributions are tax-deductible,
• Earnings grow tax-free, and
• Withdrawals for qualified medical expenses are tax-free.

HSAs can serve as tax-efficient investment vehicles for healthcare expenses in retirement.

Tax loss harvesting involves selling investments that have experienced losses to offset capital gains and reduce taxable income. The steps of tax loss harvesting include:

1. Review your investment portfolio to identify securities that have declined in value since purchase.
2. Sell the investments that have experienced losses.
3. Use the realized losses to offset any capital gains you may have incurred from the sale of other investments. By doing so, you can reduce or eliminate the taxes owed on those gains.

If your total losses exceed your total gains, you can use the excess losses to offset up to $3,000 of your ordinary income per year. Any remaining losses can then be carried forward to future years to offset future gains or income.

After selling investments at a loss, consider reinvesting the proceeds in similar, but not identical, securities to maintain your desired portfolio allocation. If you repurchase the same or a substantially identical security within 30 days before or after the sale, you will have committed a wash sale violation and you will not be able to claim a tax loss.

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Capital gains are profits earned from the sale of assets such as stocks, bonds, real estate, or mutual funds. They can be classified as short-term or long-term, depending on the holding period of the asset. Short-term capital gains are taxed at ordinary income rates, which can be higher than long-term capital gains tax rates. Long-term capital gains, on the other hand, are taxed at rates that are typically lower than ordinary income tax rates. Due to these preferential rates for long-term capital gains, you may want to consider holding an investment for more than one year before selling to qualify for long-term capital gains treatment.

Be mindful of your current and expected future tax brackets when managing capital gains. If you anticipate being in a lower tax bracket in the future, it may be advantageous to defer realizing gains until then.

Retirement accounts offer various tax benefits, such as tax-deferred or tax-free growth, and may provide opportunities for tax deductions or credits. Common retirement accounts include 401(k) plans, traditional Individual Retirement Accounts (IRAs), Roth IRAs, and 403(b) plans.

401(k) plans are employer-sponsored retirement accounts offered by many companies. Employees can contribute a portion of their pre-tax income to the plan, reducing their taxable income for the year. Contributions grow tax-deferred until withdrawal, typically in retirement. Some employers may also offer matching contributions, which can further boost retirement savings.

Traditional IRAs allow individuals to make tax-deductible contributions, subject to certain income limits. Like 401(k) contributions, contributions to traditional IRAs reduce taxable income in the year they are made. Investments within the account grow tax-deferred until withdrawal, at which point they are taxed as ordinary income. You must start taking required minimum distributions (RMDs) from your traditional IRA once you reach age 72.

Roth IRAs differ from traditional IRAs in that contributions are made with after0tax dollars, meaning contributions are not tax-deductible. However, qualified withdrawals, including earnings, are tax-free, providing tax-free income in retirement. Roth IRAs also offer more flexibility, as contributions (but not earnings) can be withdrawn penalty-free at any time, and there are no RMD requirements during the original account holder's lifetime.

403(b) plans are retirement accounts offered by certain non-profit organizations, such as schools, hospitals, and religious organizations, as well as certain government entities. Contributions to 403(b) plans are made on a pre-tax basis, similar to 401(k) plans, and earnings grow tax-deferred until withdrawal.

In retirement, carefully plan the sequence of withdrawals from various accounts to minimize tax implications. This might involve tapping taxable accounts first to allow tax-deferred retirement accounts to keep growing.

Roth conversions involve transferring funds from a traditional retirement accounts, such as a traditional IRA or a 401(k), into a Roth IRA. This conversion typically triggers a tax liability because contributions to traditional retirement accounts are made with pre-tax dollars, while Roth conversions require paying taxes on the amount converted.

When you convert funds from a traditional retirement account to a Roth IRA, the converted amount is treated as taxable income in the year of conversion. This means you'll owe income taxes on the converted amount based on your current tax rate. However, you don't have to convert the entire balance of a traditional retirement account all at once. Partial Roth conversions allow you to convert a portion of the account balance each year, spreading out the tax liability over time and potentially minimizing the impact on your tax situation.

There are advantages to converting to a Roth IRA. First, unlike traditional retirement accounts, qualified withdrawals from Roth IRAs, including earnings, are tax-free in retirement. This can provide tax diversification in retirement and potentially reduce your tax liability. Second, Roth IRAs are not subject to required minimum distributions (RMDs) during the original account holder's lifetime, allowing for more flexibility in retirement planning and potentially tax savings. Lastly, Roth IRAs can be advantageous for estate planning because they can be passed on to heirs tax-free, subject to certain rules.

There are a few considerations to keep in mind before converting to a Roth IRA. You'll want to assess the tax implications of a Roth conversion, including the impact on your current tax rate and potential future tax rates. Converting a large sum could push you into a higher tax bracket, so it's essential to consider the timing and amount of the conversion. Additionally, ensure that you have sufficient funds outside of the retirement account to cover the taxes owed on the conversion. Using funds from the retirement account itself to pay taxes can reduce the amount converted and diminish the benefits of the conversion. Finally, evaluate your time horizon and retirement goals to determine if the potential tax-free withdrawals from a Roth IRA align with your needs and objectives.

Charitable giving not only benefits the recipients but can also provide tax advantages for donors. Cash donations are the most straightforward form of charitable giving, but there are other ways to donate that can provide further tax benefits.

Donating appreciated assets, such as stocks, real estate, or other investments, can provide additional tax benefits. By donating appreciated assets directly to a charity, you can avoid paying capital gains tax on the appreciation while still receiving a charitable deduction for the fair market value of the assets.

Donor-advised funds (DAFs) are charitable giving vehicles that allow donors to make contributions to a fund and then recommend grants to qualified charities over time. Contributions to DAFs are tax-deductible in the year they are made, providing immediate tax benefits, while grants from the DAF can be distributed to charities at a later date.

Charitable remainder trusts (CRTs) and charitable lead trusts (CLTs) are types of charitable trusts that allow donors to make charitable contributions while retaining some benefits for themselves or their beneficiaries. These trusts can provide tax benefits and estate planning advantages.

Individuals who are age 70 and a half or older can make qualified charitable distributions (QCDs) directly from their IRA to a qualified charity. QCDs do count toward the required minimum distribution (RMD) for the year and are excluded from taxable income, providing benefits for retirees.

Estate tax planning strategies are designed to minimize the impact of estate taxes on the transfer of wealth to heirs and beneficiaries. Estate taxes are taxes imposed on the transfer of assets from a deceased individual to their heirs or beneficiaries.

One of the simplest and most effective estate tax planning strategies is to make lifetime gifts to heirs and beneficiaries. By gifting assets during your lifetime, you can reduce the size of your taxable estate and potentially lower estate tax liabilities. Each year, individuals can gift up to the annual gift tax exclusion amount ($18,000 for 2024) to an unlimited number of recipients without incurring gift taxes. Additionally, individuals can make larger gifts to heirs over their lifetime, taking advantage of the lifetime gift tax exemption ($13.61 million for 2024). In addition to the annual gift tax exclusion, individuals can make unlimited payments for tuition and medical expenses on behalf of others without incurring gift taxes. These payments are excluded from the gift tax calculation, providing an additional estate tax planning opportunity.

Another popular estate planning tool is an irrevocable trust. Irrevocable trusts allow individuals to transfer assets out of their taxable estate while retaining some control over the assets. Assets transferred to an irrevocable trust are no longer considered part of the individual's estate for tax purposes, potentially reducing estate tax liabilities. Common types of irrevocable trusts used for estate tax planning include irrevocable life insurance trusts (ILITs), grantor retained annuity trusts (GRATs), and charitable remainder trusts (CRTs).

Life insurance can be an effective estate tax planning strategy, particularly for individuals with large estates who may have significant estate tax liabilities. Life insurance proceeds are generally not subject to income tax and can be used to pay estate taxes, providing liquidity to cover tax liabilities without having to sell assets. ILITs are often used to hold life insurance policies outside of the taxable estate and avoid estate taxes on the death benefit.

A Qualified Personal Residence Trust (QPRT) is a specialized type of irrevocable trust that allows individuals to transfer their primary residence or vacation home out of their taxable estate while retaining the right to live in the property for a specified term. At the end of the term, the property passes to the beneficiaries named in the trust, potentially reducing estate tax liabilities.

Lastly, the portability provision allows a surviving spouse to inherit any unused portion of their deceased spouse's estate tax exemption. This means that married couples can effectively double their estate tax exemption by properly structuring their estate plans to take advantage of portability.

By implementing these tax-efficient strategies, you can take proactive steps to safeguard and grow your wealth while minimizing your tax burden. Working with a financial advisor can help you tailor these strategies to your individual financial situation and adjust your wealth management plan to optimize tax efficiency.

Ready to take control of your financial future? Start building your tax-efficient wealth management plan today by leveraging the expertise and resources of our team at Watersound Wealth Advisors. With over $4.8 billion assets under management (AUM) and experience with helping over 1,800 clients optimize their wealth, we'd welcome the opportunity to help you reach your financial goals. Contact us here to learn more and schedule your complimentary Portfolio X-Ray.