Taxes 101


In November of 1789, Benjamin Franklin wrote to a friend to inquire about his health and give a brief update on his life. His letter included this line “Our new Constitution is now established, everything seems to promise it will be durable; but, in this world, nothing is certain except death and taxes.” This infamous line rises to the front of our minds every year as we think about minimizing the pain of next year’s tax bill. 

Here are three considerations for investors as we approach the end of 2022:

1. Take advantage of tax-efficient retirement accounts that are available. 

For people accumulating wealth, trying to achieve the highest possible returns may be tempting. While this is certainly a goal of many investors, this goal may be easier to achieve if we approach this goal with taxes in mind. Investors are usually well served by taking advantage of tax-efficient retirement accounts that are available to them. Contributing to IRAs, Roth IRAs, and 401(k) accounts have tax benefits. For instance, IRA contributions may be federally tax deductible and grow tax-deferred. While investing only in tax-deferred accounts may be tempting, investing in more traditional brokerage accounts may set investors up to lower their overall lifetime tax bill in retirement. In other words, diversify across account types so that you have more options for withdrawals in retirement. It is also a good idea to evaluate the types of investments held in each account. For example, funds that generate taxable income or funds with high turnover may be better held in tax-deferred accounts. It is always important to consider the impact of sales and, if possible, aim to keep investments long enough to be subject to long-term (not short-term) capital gains. Next week we will cover Tax Loss Harvesting extensively as well.

2. While planning for taxes is essential as you accumulate wealth, it is perhaps even more important in retirement.

Kyle Sims, one of our founding partners, works extensively with clients in the retirement stage of life. Traditional investment advice suggests that retired investors should withdraw first from taxable accounts, then from tax-deferred accounts, and finally from Roth accounts where withdrawals are tax-free. Kyle points out that this advice may result in an uneven tax bill and references a recent article published by Fidelity. This article suggests that many investors can lower their lifetime tax bill by taking distributions from multiple accounts pro-rata over the life of their retirement plan. Kyle noted that it is always important to consult a tax advisor before distributing from these accounts. It is also noteworthy that a Morningstar Study published in 2013 suggested that Asset Location and Withdrawal Sourcing might increase Retirement Income by 3.23% over the life of a retirement plan. This further drives home the point that funding these accounts appropriately during the accumulation stage is only half the battle for retirees.

3. Balance generosity with tax efficiency. 

Finally, many people approach the end of the year with a desire to balance financial generosity and tax efficiency. The annual gift tax exclusion for 2022 is $16,000 ($32,000 for spouses splitting gifts) per person. Any gift over this limit will reduce the federal lifetime exemption and require appropriate tax filings. However, grandparents (for example) can make direct payments to educational institutions on behalf of their grandchildren. There are currently no limits on these payments, but payments must be made directly to the educational institution.

Additionally, the IRS has established special interest rates (Applicable Federal Rates) that allow for intra-family loans. This strategy will enable parents or grandparents to lend money to their heirs for specific purposes such as a home purchase or to start up a business. These are just some of the strategies that may be useful to consider as we approach the year-end.

While taxes may be inevitable, an informed investor may be able to reduce the amount of taxes that they and their heirs have to pay. Work with an advisor to lower your tax bill so that you can enjoy the holiday season with a little more jingle in your pockets.

This explanation is provided for informational purposes only and is not to be construed as or considered to be legal or tax advice.  You should always consult your tax advisor with any and all questions regarding any all tax and tax-related matters, including any questions that you may have concerning tax strategies described generally above.

Michel French
Senior Vice President of Investments