How to Minimize Lifetime Taxes
By Kevin Estes
Progressive Income Tax
Taxes are complex. However, the simple version is:
The more you make, the more they take.
The federal marginal income tax rates range from 0% to 37%:
Source: IRS provides tax inflation adjustments for tax year 2024
However, it’s possible to Judo throw this model.
Only Applies to Some
Taxpayers don’t pay their highest rate on all of their income!
They pay the lower tax bracket rates first.
Example:
Let’s pretend a married couple files a 2024 joint tax return with:
earned income of $250,000,
the standard deduction, and
has no other income, deductions, or credits.
They would pay a federal total of $39,077 in income tax:
0% of the first $29,200 up to the standard deduction, or $0
10% of the next $23,200 ($52,400 - $29,200), or $2,320
12% of the next $71,100 ($123,500 - $52,400), or $8,532
22% of the next $106,750 ($230,250 - $123,500), or $23,485
24% of the next $19,750 ($206,550 - $230,250), or $4,740
That would be an effective rate of 15.6% ($39,077 / $250,000).
Had all of their income been taxed at their highest 24% tax bracket, they would have paid $60,000!
Minimize Lifetime Taxes
Many people - including tax preparers - focus on reducing taxes for the previous year.
Some take steps to reduce their tax bill for this year.
Very few proactively minimize their lifetime taxes.
It’s even possible that minimizing one year’s taxes could increase lifetime taxes!
Potential Lifetime Taxes
Here’s a made up example of someone’s lifetime taxes.
Let’s say they’re:
49 years old,
will work until age 57, and
may live to 90.
Without any adjustments, their future taxes might look like:
Smoothing Taxes Can Save
Federal taxes are based on income - not wealth!
It may be possible to lower lifetime income taxes tens or even hundreds of thousands of dollars by:
lowering income in high-tax years and
raising income in low-tax years.
Minimize Current Taxes
Potential ways to lower current taxes include:
contribute to pre-tax plans
hold income investments in tax-advantaged accounts
benefit from long-term capital gains
make after-tax contributions
1. Contribute to Pre-Tax Plans
Funding traditional accounts can lower taxable income and current taxes.
Retirement
Pre-tax contributions to workplace retirement accounts like a 401(k), 403(b), and 457(b). The maximum contribution for these accounts is $23,000 for 2024.
There’s also a catch-up for those 50 and older of $7,500 for the 401(k) and 403(b). The 457(b) catch-up works a little differently.
There are other accounts such as an Individual Retirement Arrangement (IRA). Whether contributions are deductible depends on income limits.
Also, don’t forget about spousal IRAs! They’re a way for non-working spouses to save for their retirement and reduce the family’s taxes.
For more, check out: Ignoring the Spousal IRA?
Health Savings Accounts (HSAs)
Another option is to contribute to a Health Savings Account (HSA).
Contributions are triple tax advantaged in that they:
lower tax on the front end,
grow tax free, and
pay medical expenses tax free.
Health Savings Accounts are not “use it or lose it.” They’re portable and can move with an employee if they leave the company.
HSAs can also be invested. They often require a relatively small balance - such as $2,000 - be kept in cash. The rest can be invested.
An individual or family can only contribute to a Health Savings Account if they’re on a qualifying High Deductible Health Plan.
It’s important to not let the tax tail wag the healthcare dog! A high deductible plan needs to be right for an individual or family.
For more, check out: Pros and Cons of a Health Savings Account
Flexible Spending Accounts (FSAs)
The middle term is different and important!
Unlike a Health Savings Account, a Flexible Spending Account is generally “use it or lose it.” Most of the funds must be spent by year end.
Two common options are:
Dependent Care FSA
Healthcare FSA
If someone has high confidence they’ll have qualifying expenses, these programs may save on taxes. However, restrictions apply and funds may be forfeited after a change in employment.
2. Hold Income Investments in Tax-Advantaged Accounts
Many investments earn very little income. For instance, growth stocks rarely pay dividends.
It may make sense to keep taxable bonds in tax-advantaged accounts. However, it does not make sense to hold tax-free municipal bonds in traditional or Roth retirement accounts.
3. Benefit from Long-Term Capital Gains
The gain on some investments may be taxed at the lower long-term capital gain rates:
0%
15%
20%
The rate depends on income and the capital gain tax brackets published by the IRS. 15% is common.
Investments generally need to be held for over a year before they’re sold to receive the long-term capital gain tax treatment. Those held less than a year are taxed at ordinary income tax rates.
Dividends can also receive the long-term capital gain treatment. To qualify, the stock typically needs to have been held for over a year.
Whether to hold long-term investments in a tax-advantaged or taxable brokerage account depends on the taxpayer’s situation, needs, and goals. Higher income investors may be subject to an extra 3.8% Net Investment Income Tax.
4. Make After-Tax Contributions
Some company plans now offer after-tax retirement accounts. These are different than Roth accounts!
After-tax accounts allow individuals to fund more than the regular limit.
it’s especially helpful for higher earners looking to save after maximizing pre-tax contributions to:
retirement accounts
Health Savings Account
According to the IRS, the 2024 contribution limits are:
$23,000 for employee deferrals to pre-tax 401(k), 403(b), and 457(b)
$69,000 in total defined benefits
The company match also counts toward the $69,000 limit.
Example:
Jen is a 45 year-old who earns a $200,000 salary and a $50,000 annual bonus. Congratulations!
Jen maxes her pre-tax 401(k) contributions at $23,000. Her employer also matches $10,000 (4% of $250,000).
That leaves her $36,000 to contribute to her after-tax account:
$69,000 total defined benefits limit
less $23,000 employee contribution
less $10,000 company match
These funds are taxed on the front end. If certain conditions are met, they may never be taxed again!
Contributions could lower taxes both in-year and for future years.
The biggest downsides are:
after-tax plans are still uncommon
the funds are less accessible than a traditional brokerage account
After-tax contributions can often be rolled into a Roth IRA. The income limits do not apply. This process is called a Mega Roth or Mega Backdoor Roth.
Don’t worry! Congress blessed it.
Minimize Future Taxes
Potential ways to lower future taxes include:
avoid penalties
use the real estate exclusion
save receipts
do Roth conversions
delay Social Security
give strategically
1. Avoid Penalties
Perhaps the simplest way to minimize taxes is to avoid penalties.
A 10% penalty applies for those who access pre-tax retirement accounts before age 59.5 unless an exception applies.
The IRS can also charge under-payment penalties. Solutions could include:
making quarterly estimated tax payments
increasing withholding on Form W-4 with an employer
reducing taxable income
2. Use the Real Estate Exclusion
Real estate receives many tax benefits, including the ability to exclude a portion of the gain of a home sale.
The taxpayer would need to both own and live in the property for:
at least two (2)
of the last five (5) years.
According to the IRS, the tax exclusion for a qualifying residence is:
$250,000 single
$500,000 married, filing jointly
Life choices matter more! However, it may make sense to consider this exclusion if planning to move.
3. Save Receipts
It’s also important to keep track of expenses.
Home
Some expenses may increase the cost basis of the home. Doing so could reduce the tax due on a home sale.
Medical and Dental
Medical and dental expenses above 7.5% of Adjusted Gross Income may be deductible. Keeping those receipts can help lower tax bills.
Also, qualifying medical expenses need not be reimbursed by Health Savings Accounts (HSAs) right away. Waiting can allow the account to grow longer. However, it’s critical to store the medical receipts and documentation in a safe place physically and/or digitally.
Itemized
Charitable contributions and donations may also lower taxes for the year. Other taxes paid could as well. If someone is planning to itemize deductions, it may make sense to systematically save the receipts!
4. Do Roth Conversions
Another option to lower future taxes is to convert pre-tax to Roth accounts. Doing so increases taxable income in-year yet may avoid future taxes.
It’s especially helpful to do Roth conversions in a year with lower income. Doing so could limit future Required Minimum Distributions (RMDs), which might significantly increase taxes later in life.
Roth conversions can also benefit heirs. If a loved one inherits a traditional (pre-tax) account, they’ll need to pay the taxes the deceased didn’t! Those taxes might occur when they’re in their peak earning years.
Whether to do Roth conversions depends on each person’s specific circumstances. Depending on the size of the tax-deferred accounts, it may make sense to convert up to the top of the:
12%,
22%, or
24%
tax bracket each year.
5. Delay Social Security
Each year Social Security retirement benefits are delayed increase the monthly payment.
For those born in 1943 or later, each year delayed increases the monthly benefit 8%. Benefits can be delayed until age 70.
It’s not like an 8% investment return. It’s more like an annuity. That higher payment will persist for the life of the individual and may transfer to a surviving spouse.
However, there is also a tax benefit! Up to 85% of Social Security benefits are taxed. Delaying the payments delays the tax.
Of course, it depends on each household’s specific situation. If the money is needed or someone has a short expected lifespan, it may make sense to start taking the benefits earlier.
6. Give Strategically
Giving cash may not be ideal.
Tax-Deferred Accounts
Someone may be able to receive a full deduction on a contribution of a tax-deferred account like a 401(k), 403(b), 457(b), or IRA.
The nonprofit doesn’t care because they don’t pay income taxes! However, it could save the donor income tax.
Qualified Charitable Distributions (QCDs) are a version of this type of giving. These distributions can satisfy the annual Required Minimum Distributions (RMDs) while avoiding the income tax.
Appreciated Assets
Another trick is to give appreciated assets instead of cash. Doing so avoids the capital gains tax from selling the assets.
It rarely makes sense to donate or gift an asset which is worth less than its original cost. Typically, sell the asset for the deduction and give cash.
Bunching
Bunching is another clever technique. Giving every week, month, or year may not maximize charitable deductions.
The Tax Cuts and Jobs Action (TCJA) nearly doubled the standard deduction. That made it harder for charitable contributions to lower taxes.
It may make sense to make a really big deduction which covers multiple years. More of the contributions would likely be deductible. The taxpayer could use the standard deduction in the other years.
Donor Advised Fund (DAF)
Individuals can contribute to a DAF now and suggest it be distributed to specific charities later. A Donor Advised Fund does not distribute funds to every charity so it’s worth checking beforehand!
DAFs are particularly good at supporting:
large contributions (bunching) and
appreciated assets.
A nonprofit may not have the resources to use appreciated assets. A Donor Advised Fund may. However, each situation is unique!
I hope this helps!
If you’re interested in a review of your specific situation…
Disclaimer
In addition to the usual disclaimers, neither this post nor these images include any financial, tax, or legal advice.
