Tax Allocation and Optimization Strategies for Working Professionals

Author: Tara Shulman, Principal Wealth Advisor

As a busy professional, you're focused on excelling in your career and making the most of your hard-earned income. However, without a solid tax strategy, you could be leaving money on the table.

In this guide, we'll explore tax allocation and optimization strategies that can help you keep more of your wealth and set you up for long-term financial success.

Understanding tax allocation

Tax allocation is the strategic placement of different types of investments across various account types to minimize your overall tax burden. By understanding the tax implications of different investment vehicles and account types, you can make informed decisions about where to hold your assets.

Types of investment accounts

Before we dive into allocation strategies, let's review the three main types of investment accounts:

1. Tax-deferred accounts: These include traditional 401(k)s and IRAs. Contributions are made with pre-tax dollars, reducing your current taxable income. However, you'll pay taxes on withdrawals in retirement.
2. Tax-exempt accounts: Roth 401(k)s and Roth IRAs fall into this category. Contributions are made with after-tax dollars, but growth and qualified withdrawals are tax-free.
3. Taxable accounts: These are standard brokerage accounts where you invest with after-tax dollars and pay taxes on dividends and capital gains as they occur.

How to create a tax-efficient allocation strategy

The key to effective tax allocation is understanding which investments belong in which types of accounts. Here are some general guidelines:

1. High-growth, dividend-paying stocks: These are often best held in tax-exempt accounts like Roth IRAs. This allows you to benefit from tax-free growth and avoid paying taxes on dividends.
2. Bonds and other income-generating investments: Consider keeping these in tax-deferred accounts. The interest from these investments is typically taxed as ordinary income, so sheltering them in a tax-deferred account can lead to significant tax savings.
3. Long-term holdings: Use taxable accounts for investments you plan to hold long-term, such as low-turnover index funds. These can benefit from preferential long-term capital gains tax rates.
4. Real Estate Investment Trusts (REITs): Consider holding these in tax-deferred or tax-exempt accounts, as their dividends are typically taxed as ordinary income.

Tax allocation in practice: Example

Let's illustrate the impact of tax allocation with an example.

Imagine you have $500,000 to invest, split evenly between a stock yielding 2% in dividends and a bond fund yielding 4% in interest. You're in the 37% tax bracket.

Scenario A: Putting the stock in a taxable account and the bond fund in a traditional IRA.

• Result: You'll pay taxes on $10,000 of qualified dividends (likely at a preferential rate) and defer taxes on $20,000 of bond interest.

Scenario B: Putting the stock in a traditional IRA and the bond fund in a taxable account.

• Result: You'll pay taxes on $20,000 of bond interest at your ordinary income tax rate (37% in this case) and defer taxes on $10,000 of dividends.

Scenario A is generally more tax-efficient, potentially saving you thousands of dollars in taxes each year.

Tax optimization strategies

While tax allocation focuses on where to hold your investments, tax optimization involves a broader set of strategies to minimize your overall tax burden.

Here are some key tactics to consider.

1. Maximize retirement account contributions

One of the most straightforward ways to reduce your current tax burden is to maximize contributions to tax-advantaged retirement accounts. For 2024, the contribution limits are:

• 401(k), 403(b), and most 457 plans: $23,000 ($30,500 if you're 50 or older)
• Traditional and Roth IRAs: $7,000 ($8,000 if you're 50 or older)

By maxing out these accounts, you can potentially reduce your taxable income by tens of thousands of dollars each year.

2. Leverage health savings accounts (HSAs)

If you have a high-deductible health plan, an HSA can be a powerful tax optimization tool. HSAs offer a triple tax advantage:

1. Contributions are tax-deductible
2. Growth within the account is tax-free
3. Withdrawals for qualified medical expenses are tax-free

For 2024, you can contribute up to $4,150 for individual coverage or $8,300 for family coverage, with an additional $1,000 catch-up contribution if you're 55 or older.

3. Implement tax-loss harvesting

Tax-loss harvesting involves selling investments that have declined in value to offset capital gains in your taxable accounts. This strategy can help reduce your tax liability while maintaining your overall investment strategy.

For example, if you have a stock that has lost $10,000 in value, you could sell it to realize the loss. This loss can then be used to offset $10,000 in capital gains, reducing your tax bill. If you don't have enough gains to offset, you can use up to $3,000 of losses to offset ordinary income and carry forward any remaining losses to future years.

Be aware of the wash-sale rule, which prohibits claiming a loss on a security if you buy the same or a "substantially identical" security within 30 days before or after the sale.

4. Consider Roth conversions

If you expect to be in a higher tax bracket in retirement, converting some of your traditional IRA to a Roth IRA could be beneficial. While you'll pay taxes on the conversion now, future withdrawals will be tax-free.

This strategy can be particularly effective in years when your income is lower than usual, allowing you to convert at a lower tax rate. It's also a way to reduce future required minimum distributions (RMDs) from your traditional IRA, which could push you into a higher tax bracket in retirement.

5. Optimize charitable giving

If you're charitably inclined, there are a few tax-efficient ways to give:

1. Donate appreciated securities: By donating stocks or other securities that have appreciated in value, you can avoid capital gains taxes and still receive a deduction for the full market value of the securities.
2. Donor-Advised Funds (DAFs): These allow you to make a large charitable contribution in one year (and take the tax deduction), but spread out the actual charitable gifts over time.

6. Utilize tax credits

Don't overlook available tax credits, which provide a dollar-for-dollar reduction in your tax bill. Some credits to consider include:

• Child Tax Credit
• Child and Dependent Care Credit
• American Opportunity Tax Credit (for education expenses)

7. Consider municipal bonds

For high-income professionals, municipal bonds can be a smart investment. The interest from these bonds is often exempt from federal taxes and sometimes state and local taxes as well. While the yields might be lower than corporate bonds, the tax savings can make them more attractive on an after-tax basis.

8. Time your income and deductions

If possible, try to time your income and deductions strategically. For example:

• If you expect to be in a lower tax bracket next year, consider deferring some income to then.
• If you're in a high tax bracket this year, you might want to accelerate deductions into the current year.

This strategy requires some planning and consideration of your overall financial situation.

Putting it all together: Creating your personal tax strategy

Now that we've covered various tax allocation and optimization strategies, how do you put it all together? Here are some steps to guide you:

1. Assess your current situation: Start by getting a clear picture of your current financial state, including your income, investments, and tax situation.
2. Set clear goals: Define your short-term and long-term financial goals. These will guide your tax planning decisions.
3. Find the strategies that work for you: Review your investment accounts and ensure you're holding different types of investments in the most tax-efficient accounts.
4. Maximize your tax-advantaged accounts: Make sure you're taking full advantage of 401(k)s, IRAs, and HSAs.
5. Explore additional optimization strategies: Consider which of the other strategies (like tax-loss harvesting or Roth conversions) might work for your situation.
6. Regular review and adjustment: Tax laws change, and your financial situation evolves. Make sure to review and adjust your tax strategy regularly.
7. Get professional advice: Tax planning can be complex. Consider working with a financial advisor or tax professional who can provide personalized advice based on your specific situation.

Conclusion

As a busy professional, optimizing your tax situation might seem like a daunting task. However, the potential savings make it well worth the effort. By implementing the right tax allocation and tax optimization strategies, you can significantly reduce your tax burden and keep more of your hard-earned money.

Remember, everyone's financial situation is unique, and what works for one person may not be the best strategy for another. That's why it's crucial to work with a financial advisor who understands your specific needs and goals.

At Compound Planning, we specialize in helping busy professionals like you navigate the complexities of tax planning. Our integrated approach combines tax advisory, financial planning, and investment management to provide a comprehensive solution tailored to your needs.

Ready to take control of your tax situation and optimize your finances? Sign up for our dashboard to get a clear picture of your financial health, or schedule a free consultation with one of our advisors.