Tax planning opportunities you might not be aware of

Smart investment choices now can reduce your taxable income pre- and post-retirement, as well as set funds aside for when you'll need them in the future.

Whether you're focusing primarily on your taxes or you're structuring your investment portfolio, by utilizing these often-overlooked tax-planning strategies and thinking outside the box, you can set both yourself and your family up for a prosperous financial future.

The basics of a roth conversion

Roth conversions allow traditional IRA holders to transfer a portion of their IRA funds to their Roth IRA. A traditional IRA is beneficial because the contributions are tax-free; that is, contributors don't have to pay taxes when they make the contribution, and the funds grow tax-free until they are withdrawn, at which point they're taxed as ordinary income. Roth IRAs, on the other hand, have post-tax contributions but allow the funds to grow and be withdrawn tax-free.

As a general rule, most financial experts will recommend you invest in a traditional IRA when your tax bracket is currently higher than you expect it to be in retirement, and you should invest in a Roth IRA when your current tax bracket is low so you pay taxes at the most advantageous time.

If you have money in a traditional IRA, the IRS allows you to convert some or all of that money into a Roth. You pay taxes (but no penalties) on the income you “withdraw” and immediately recontribute it into a Roth IRA. There are several advantages to this, including:

1. You may be temporarily in a lower tax bracket now than when you made the contributions to your traditional IRA. So, you can effectively convert it to a Roth at a discount.
2. You can shift more funds into a more versatile account. With a Roth IRA conversion, you can withdraw your principal (but not earnings) at any time once they’ve been vested for five years, and you don't have to take required minimum distributions in retirement.
3. You might not otherwise have access to a Roth IRA. If you make more than $140,000 ($208,000 for households), then you're not eligible to make Roth IRA contributions. But a conversion gives you access to this account type and its benefits.

However, one disadvantage of an IRA conversion is that it can increase your Medicare insurance premiums later. For example, we had a client who could gain a $2 million lifetime boost to his assets if he converted them from a traditional IRA to a Roth, but the switch would raise his Medicare premiums by $4,000 for the year around the time of the conversion.

While you should be aware of these disadvantages, it's important to weigh them against the total benefits. When you have completed your Roth conversion and your income has gone down to a lower amount the following calendar year, you can file a Form SSA-44 with the IRS and your annual premiums will be lower.

Another route to building up your Roth IRA is overfunding your 401(k). If you make post-tax contributions to your 401(k), you can add those funds to a Roth IRA after retirement in order to access the more versatile account benefits.

Start a 529 plan

A 529 plan is a tax-advantaged account for saving for future educational expenses. This can be for you, for a current dependent or any other identified recipient. Contributions to a 529 plan are tax-deferred, and residents who live in states with a state income tax realize more benefits than those who don't pay state taxes. Individual states sponsor different 529 plans, so shop around for the best fit for your needs, even outside of the state you live in. 529 plans are also extremely versatile; they can be used for college costs (as long as the user enrolls in 12 credits or more) and can increasingly be used for K-12 qualified expenses.

Prioritize your HSA

If you have a high deductible health plan (HDHP), then you have access to an HSA. You can invest pre-tax dollars into this account and make tax-free withdrawals for qualified health care-related purchases. There are a lot of different benefits to maxing out your HSA (to the tune of $3,650 for individual accounts and $7,300 for family accounts in 2022):

• First, those contributions aren't taxed.
• Second, the interest you gain from the investment is tax-free.
• Third, when you withdraw funds for qualified purchases, that money isn't taxed either (whether you're drawing from the principal or the interest). 

If you don't have qualifying medical expenses, that's OK — once you reach the distribution age of 65, you can withdraw the funds you contributed for any type of expenses tax-free (you’d have to pay taxes on any investment gains you spend on non-medical expenses, though). That can make an HSA more powerful than both a traditional IRA (the pre-tax account) and a Roth IRA (the post-tax account). Maxing out your HSA should definitely be on your tax planning to-do list.

Start planning your tax strategies well before tax season

The best tax strategies are long-term savings plans that let you minimize this year's taxable income and help you create robust investments for future use. 

In fact, the personal finance community has reached a general consensus on how to prioritize your investments for minimum taxes and maximum retirement benefits. Follow these steps:

1. Invest in your workplace retirement plan to max out employer contributions.
2. Max out your HSA.
3. Max out your IRA.
4. Fill up the rest of your workplace retirement plan with whatever’s left.

Depending on the benefits available to you, you can also modify your “order of operations” to include Employee Stock Purchase Plans, starting a second source of income to invest in an SEP IRA, or other options.

Allocating your money to tax-advantaged accounts isn't a last-minute tactic. Talk to your payroll department — and your financial adviser or accountant — before the end of the current tax year so you can maximize your financial potential.

This article was written by Adam Lampe from Kiplinger and was legally licensed through the Industry Dive publisher network. Please direct all licensing questions to legal@industrydive.com.