9 Places I Put Money to
Minimize Income Tax at Withdrawal
Brad Rosley CFP®
Premise: Uncertainty of future tax rates – how
high will they go?
By now most people should be aware that the U.S. has a deficit of about $20,000,000,000,000 (see
live debt clock and how much these numbers have grown since I wrote this in May, 2012) or over
$166,000 per taxpayer! This number is growing rapidly at an accelerating rate. Now a days, the U.S.
(and IL) government is spending more money than it takes from taxes (the debt has grown over $5
trillion in just the past 3 years). Government entitlement (SS, Medicare, Medicaid, food stamps,
etc.) expenses are mushrooming out of control with no end in sight. Almost half the country is
dependent on the government for a paycheck and about 50% of the country does not pay any
income tax. Incidentally, when I told this fact to my high school intern, he wondered how all those
people got away without paying tax, thinking they must be criminals. Of course, our current tax
code leaves the HUGE TAX BURDEN on the rest of us that do pay income tax on what we earn. My
concerns are for the huge middle class that is potentially in for a rude awakening. By the way, if the
U.S. Government confiscated all the wealth from the top 1% of the richest people in this country it
wouldn’t make a dent in this problem. So taxing the super-rich is not the solution.
While I think we could climb out of this mess by significantly growing the economy and reworking
entitlement programs, I have little faith in this happening. This leads me to believe that tax rates are
headed higher down the road.
Given this premise, what vehicles do I choose to invest in?
Given that everyone’s personal situation differs, these are laid out in no particular order and may or
may not be appropriate for your situation. I gave each of these items a brief description highlighting
some key features. These are the places that I choose to put my money and/or my client’s hard
earned money in depending on the situation.
1. 529 College Savings Plans
Tax Benefits: If you are planning on helping pay for your children’s (or grandchild’s) college
education this is a terrific place to save. I have three children that I will help pay for college. By
using a 529 College Savings Plan, the growth in the accounts is tax-deferred. That means zero tax on
the growth while the money is in the account. When I pull it out to pay for college, zero tax is
owed. In summary, once I put the money away, I should not have to ever pay tax on it again. As an
additional bonus, I use the IL Bright Directions plan and as a resident I get to take a IL state tax
deduction for the first $20,000 I invest each year. A twenty thousand dollar deduction from my
income saves me $1,000 per year in Illinois income tax. This is true for grandparents as well if they
contribute.
Can they use the money for any school? With 529 plans, the beneficiaries can use the money for
any college they may attend; public or private.
How does the money get invested? There are usually three choices available for the money to be
invested. Many providers offer popular “Age-Based” options that investors can choose between.
These vary in portfolio allocation (Aggressive, Moderate, Conservative, etc.) and investors can
choose the portfolio they would like. With this choice, the portfolio allocation will get more and
more conservative as the child nears college age. A second option is to choose a fixed portfolio
allocation that does not change as the beneficiary ages and the last option allows the account
owner (usually parent) to create their own portfolio from a predetermined menu of mutual funds.
What happens to money that is not used for college? Well, you could do a tax-free change of
beneficiary and let another family member (child, niece, nephew or grandchild) become the
beneficiary and they could pull the money tax free for college. Money from a 529 plan can be used
for tuition, fees, books, supplies and equipment required for study at any accredited college,
university or vocational school in the United States and at some foreign universities. If you want to
use the money for any personal expense you would pay tax on the gain (not the money you had
already invested) in the account at your ordinary income tax rate plus a 10% withdrawal penalty on
the gain that is withdrawn.
The money can also be used for room and board, as long as the fund beneficiary is at least a halftime student. Off-campus housing costs are covered up to the allowance for room and board that
the college includes in its cost of attendance for federal financial-aid purposes.
2. Health Savings Account
Since the government mandates health insurance policies cover for so many items, medical
insurance costs have been gone up significantly over the years. I save probably $8,000 in premiums
each year by insuring my family with a high deductible health insurance plan. For my family of five, I
pay a little over $300 per month. By having a qualified high deductible policy, I am allowed to
contribute $6,750 annually to a health savings account. Tax benefit: This health savings account
contribution is federally income tax deductible. I can use the money I put away in this account to
pay for my out of pocket medical costs. The growth of the money in the account is tax deferred,
that means I pay zero income tax on the growth and when I use it for qualified medical expenses,
there is no tax on the qualified distributions. Some experts refer to this is a Medical IRA because
you can make a tax deductible contributions (NO INCOME RESTRICTIONS). Zero tax is owed on
qualified distributions plus a 100% annual tax deduction for your entire contribution!. By the time I
retire, I expect to have over $100,000 in this account. See how much you might be able to
accumulate in one of these accounts: Calculator for future value of HSA account.
What about the money I save in the account, but don’t need? Whatever I do not use is mine to
keep and stays in my account. If you take a non-medical related withdrawal, the distribution will be
taxed at ordinary income rates and is subject to a 10% penalty if done before age 65. If you wait
until age 65, you just invested in an account that worked just like a deductible IRA. It was a tax
deductible contribution, the money grew tax-deferred and you pay tax at ordinary rates when the
money is withdrawn.
What are the Investment Options? - You can choose between interest bearing checking accounts
that come with a debit card for medical expenses or you can open a brokerage account and/or
invest the money in the same vehicles as other accounts i.e. stocks, bonds, mutual funds, etc.
Personally, I like to keep $5,000 in the checking account to cover me should I have any large
medical expenses that will be subject to my deductible and I invest the money in excess of that in
my brokerage account.
3. Roth 401k
Most people are familiar with a traditional 401k and its mechanics. A Roth 401k is similar. It is an
employer sponsored retirement plan option. In addition to a traditional 401k, your employer, with
the help from the Plan Sponsor/Administrator, should give you the option to contribute to a Roth
401k. Unlike a traditional 401k, with the Roth 401k, employees that contribute a portion of their
earning to the plan DO NOT get to deduct their contribution on their income tax return. The money
in your Roth 401k account grows tax deferred while it is invested. This is the same with the
traditional 401k. The big difference is that when you take the money out after age 59 ½, it is
INCOME TAX FREE. This is my favorite part, since income tax rates may go up substantially in the
future. I love the idea of having a lump sum of money that I can choose to pull from tax free.
Do I have to withdraw Roth 401k money? NO. Unlike a traditional 401k or IRA I do not have to take
distribution at age 70 ½. With traditional 401k’s the government forces people to withdrawal their
money and pay tax at ordinary income rates weather they need it or not.
What happens to the money when I die? Great news for your beneficiaries as it passes to my
survivor’s tax free. Once I invest, I never pay tax again.
4. Permanent Life Insurance
I have owned permanent (as opposed to term) life insurance since I was 26 years old. I bought my
first policy while I was single hoping that one day I would find a bride, have kids and earn an income
that was worth replacing should I die with dependents. I guessed right and am fortunate to have a
wonderful wife and three terrific kids. While my life insurance policy is funded with after-tax
money, the growth of the cash value is tax deferred. Several years ago I withdrew about $40,000
from the cash value when I needed money for an addition on our home and the withdrawal was a
tax-free return of premium (I could withdraw money from the policy up to the amount of my
premiums income tax free or borrow against the death benefit if necessary tax free). Every
permanent life insurance policy has certain stipulations and you will need to confirm with your
agent how much of your cash value you can access and how that might affect your policy going
forward as it will affect your death benefit and future policy performance. When I die, my entire
death benefit will pass to my survivor’s income tax-free. In summary, my premiums are made with
after-tax money, the cash value grows tax-deferred and the death benefit is received tax-free.
As I look forward to being financially independent, my life insurance policy is going to greatly
enhance my retirement (if I ever retire). My death benefit will be intact whenever I happen to die. I
consider my policy’s death benefit as a future asset that will be used to replace the money I spend
during retirement. Therefore, instead of conserving principal during retirement, I will be able to
systematically spend the principal of my investments “nest egg” and give my children my income
tax-free insurance death benefit, rather than investment assets when I die. To me this is the best of
both worlds.
5. Tax Managed Portfolios
It’s Not What You Make, It’s What You Keep That Counts!
Mutual funds are required to pass through their capital gains and dividends to their shareholders.
Stock mutual funds have their goal to create as high a return as possible given the constraints of
what they can purchase. Taxes are generally not a concern. At year end, mutual fund managers are
mandated to pay out a capital gains distribution if gains from their security sales outpace the losses
from sale during the calendar year. When you have a typical portfolio of mutual funds, there is no
coordination between the different fund managers regarding what their gains or losses are
throughout the year.
In a “Tax Managed Accounts” the focus is on “what you keep”. Through proper coordination and
communication managers can take portfolio losses to offset gains and leave the shareholder with
little or no capital gain tax to pay. Yet another way to get more tax deferred growth. You will also
find these portfolios typically purchase municipal bonds that generate federally tax free income.
These accounts are best for non-IRA accounts (don’t need to worry about taxes on money in a tax
deferred IRA).
6. Non-Dividend Paying Growth Stocks
I own a little Apple stock (wish I owned more!). While the stock price of my shares has been going
up, the growth has been tax-deferred (no tax). When I sell the stock, I will pay tax, but most likely at
a preferential capital gains rate. Dividends are a return of capital from the company to its
shareholders. Many companies choose to pay a dividend as a way to attract investors as the income
is part of the total return on investment. Other companies choose to keep the money at the firm
level and reinvest as they see fit, hopefully in such a way that will grow the profitability of the
company and ultimately the share price. Dividends and capital gains rates range from 0-20% in
2016.
7. Municipal Bonds
If you loan money (buy a bond) to state municipalities, the interest you receive is federally income
tax free. Believe it or not, not all states are financial disasters like Illinois. Depending on your tax
bracket this can be a great way to receive income. Of course, there is risk in owning bonds; default
risk and interest rate risk are the two main factors to consider. AAA bonds with a short term to
maturity are ideal for conservative investors in a high tax bracket. Again, these are not a prudent
investment inside an IRA since bond income is not taxed while inside an IRA.
8. Commercial Real Estate
I own several rental properties and even though they are fully rented, I pay very little or no income
tax each year because of several main business expenses that offset the rental income from the
buildings. Again, the growth in value (if there is any) is tax deferred. Upon the sale of the property, I
could either pay tax at a capital gain rate or potentially role the proceeds into another property or
continue to defer the tax.
Some of the tax deductible expenses include:
1. Interest
Interest is often a landlord's single biggest deductible expense. Common examples of interest that
landlords can deduct include mortgage interest payments on loans used to acquire or improve
rental property and interest on credit cards for goods or services used in a rental activity.
2. Depreciation The actual cost of a house, apartment building, or other rental property is not fully
deductible in the year in which you pay for it. Instead, landlords get back the cost of real estate
through depreciation. This involves deducting a portion of the cost of the property over several
years.
3. Repairs
The cost of repairs to rental property (provided the repairs are ordinary, necessary, and reasonable
in amount) is fully deductible in the year in which they are incurred. Good examples of deductible
repairs include repainting, fixing gutters or floors, fixing leaks, plastering, and replacing broken
windows.
4. Local Travel
Landlords are entitled to a tax deduction whenever they drive anywhere for their rental activity. For
example, when you drive to your rental building to deal with a tenant complaint or go to the
hardware store to purchase a part for a repair, you can deduct your travel expenses.
If you drive a car, SUV, van, pickup, or panel truck for your rental activity (as most landlords do), you
have two options for deducting your vehicle expenses. You can: deduct your actual expenses
(gasoline, upkeep, repairs), or use the standard mileage rate (55.5 cents per mile for 2012). To
qualify for the standard mileage rate, you must use the standard mileage method the first year you
use a car for your business activity. Moreover, you can't use the standard mileage rate if you have
claimed accelerated depreciation deductions in prior years, or have taken a Section 179 deduction
for the vehicle.
9. Roth IRA
I love the Roth IRA as investors can save $5,000 per year ($6,000 if you are over age 50) of their
after tax money. It works just like the Roth 401k in that the money grows tax deferred and can be
withdrawn after age 59 1/2 income tax free. This is not an upfront income tax deduction for a Roth
IRA contribution. Unlike, a traditional IRA, you are not forced to ever take money out of your Roth
IRA.
Can I use ROTH money for anything else and avoid the 10% early withdrawal penalty? Yes
OK for school - When it comes to school costs, the IRS says no penalty will be assessed as long as
your IRA money goes toward qualified schooling costs for yourself, your spouse or your children or
grandkids.
You must make sure the eligible student attends an IRS-approved institution. This is any college,
university, vocational school or other post-secondary facility that meets federal student aid
program requirements. The school can be public, private or nonprofit as long as it is accredited.
Once enrolled, you can use retirement money to pay tuition and fees and buy books, supplies and
other required equipment. Expenses for special-needs students also count. And if the student is
enrolled at least half-time, room and board also meet IRS expense muster.
First-home exemption
Then there's your home. Uncle Sam offers various tax breaks for homeowners. He'll even bend the
IRA rules a bit to help you get into your house in the first place.
You can use up to $10,000 in IRA funds toward the purchase of your first home. If you're married,
and you and your spouse are both first-time buyers, you each can pull from retirement accounts,
giving you $20,000 in residential cash. Even better is the IRS definition of first-time homebuyer.
Technically, you don't have to be purchasing your very first abode. You qualify under the tax rules
as long as you, or your spouse, didn't own a principal residence at any time during the previous two
years. In fact, you can even share your IRA wealth. The IRS says the first-time homebuyer using your
IRA funds for a down payment can be you, your spouse, one of your children, a grandchild or a
parent.
For Roth IRA’s, the $10,000 you take out for your first home is a qualified distribution as long as
you've had your Roth account for five years. This means you can take out your retirement money
without penalty, and because Roth earnings are tax-free, you'll have no IRS bill either.
Unfortunately, there are contribution limits based on your income and the amount of your eligible
contribution gets phased out at higher income levels.
Tax laws change and your situation should be evaluated individually with your tax advisor or
Certified Financial Planner. Contact me if you have any questions about these strategies.
Brad Rosley, CFP®
630-942-9007
[email protected]
www.fortunefinancialgroup.com