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Taming Taxes: Strategies for Minimizing Your Bill

“Minimizing fees and taxes is one of Schwab’s 7 Investing Principles,” says Rob Williams, director of income planning at the Schwab Center for Financial Research, “However, taxes tend to be the more complex of the two.”

Taxes can be particularly tricky for high-income earners, who often don’t qualify for certain credits, deductions and tax-advantaged accounts. That said, there are a number of steps all investors may be able to take now to help minimize their tax bills in both the short and long terms.

Step one is to reduce your annual taxable income through tax-deferred savings accounts. To that end:

1. Maximize your 401(k)

You can shield up to $18,000 ($24,000 if you’re over age 50) in annual income through an employer-sponsored 401(k) plan.

2. Fund an Individual Retirement Account (IRA)

You may also be able to deduct up to $5,500 ($6,500 if you’re over age 50) through contributions to a traditional IRA.1

3. Enroll in a Health Savings Account (HSA)

Individuals who have high-deductible health plans2 can shield up to $3,400 in annual income through an HSA ($4,400 if you’re age 55 or older), and families can generally shield up to $6,750 ($7,750 if the account holder is age 55 or older). Contributions are generally tax-deductible;3 capital gains, dividends and interest accumulate tax-free; and you pay no tax on withdrawals for qualified medical expenses.

4. Minimize RMDs

Of course, maxing out traditional IRAs or 401(k)s today could mean a larger portfolio—and tax bill—tomorrow. That’s because required minimum distributions (RMDs) kick in at age 70½. The bigger your portfolio, the bigger your RMDs—potentially pushing you into a higher tax bracket.

For example, if you had $3 million in a traditional IRA, you’d need to withdraw roughly $110,000.4 Add other sources of income—Social Security, say, or earnings from a rental property—and you could easily land in the 28% bracket or higher in 2017.

The good news is there are several ways to try to minimize both your bracket and your tax bill in retirement, Rob says. One strategy, if you have a large traditional IRA or 401(k) balance, is to withdraw money from retirement accounts before you reach age 70½ (though not so much that it would land you in a higher bracket).

“Once you reach age 59½, you can take distributions from a traditional IRA without penalty,” Rob says. “If you start taking small withdrawals at that age, you can reduce the size of your portfolio and thus the size of your RMDs when you reach 70½.”

5. Open a Roth IRA

Another strategy is to contribute to a Roth IRA, to which RMD rules don’t apply because it’s funded with after-tax dollars. What’s more, withdrawals of earnings made after age 59½ are tax-free, provided you’ve held the account at least five years.

“If you think your tax bracket might be the same or higher in retirement than it is today, or want flexibility to manage the size of distributions and the taxes paid when you reach retirement, a Roth is worth considering,” Rob says.

Under current law, only those individuals who earn less than $118,000 ($186,000 if you’re married) can contribute the full amount to a Roth IRA for the 2017 tax year. However, even investors who exceed those limits can avail themselves of a Roth IRA conversion. (See “Consider a conversion,” below.)

Rather than settle for any single strategy, investors might consider all of the above. For people who have saved a healthy sum for retirement, it can be helpful to diversify retirement savings—dividing their money among traditional IRAs, Roth IRAs and taxable accounts holding long-term investments.

6. Put your assets in the right place

You should also try to hold your least tax-efficient investments in your most tax-advantaged accounts. The income thrown off by real estate investment trusts (REITs), for example, makes them well suited to an IRA, where any income won’t be taxed until retirement. Conversely, tax-efficient mutual funds, exchange-traded funds and stocks make more sense in a taxable investment account—provided you hold on to them for a year or more. That’s because any realized gains are subject only to long-term capital gains rates, which are generally lower than ordinary income taxes.

7. Pay attention to tax efficiency

Just as you might compare expense ratios of similar mutual funds, you can also assess the relative tax efficiency of mutual funds you plan to hold in a taxable account. You can determine how often fund managers trade—and if they produce taxable short-term gains—or whether the securities in the fund produce income in the form of dividends and/or interest.

8. Don’t go it alone

Of course, the strategies Rob suggests depend in part on a reasonably accurate estimate of how much money you’re likely to have after you’re no longer working—which can be difficult to calculate, especially if retirement is a decade or more away.

Working with a financial planner is one way to anticipate what both your savings and income might look like in retirement. And as you layer uncertainties about savings, investment performance and future spending on top of the complexities of the tax code, you might also want to enlist a certified public accountant or tax attorney. After all, a penny saved from unnecessary taxes is a penny earned toward your long-term savings.

1If you do participate in a 401(k) or similar workplace plan, the deduction may be limited or not allowed at all.

2High-deductible health plans are defined as those with a minimum annual deductible of $1,300 for individuals and $2,600 for families. Enrollees can’t be claimed as a dependent on someone else’s tax return or covered by another health plan without a high deductible, including Medicare.

3Contributions to HSA accounts are tax-deductible on a taxpayer’s federal return. You should consult with a tax professional on your ability to deduct HSA contributions on your state return.

4RMD Calculator on Example assumes an account balance of $3 million at age 70½ and a primary beneficiary who is less than 10 years younger than the account owner.

What you can do next

  • Use the Compare Funds tool to view the one-year tax cost ratio—that is, the percentage-point reduction in returns resulting from federal income taxes—for up to five funds.

  • Consult an experienced tax professional to help determine what’s best for you.

  • Talk with a Certified Financial Planner™ professional about your portfolio’s tax-efficiency when you enroll in Schwab Intelligent Portfolios PremiumTM.

  • Schedule an appointment with a local Schwab financial consultant, or call us at 800-355-2162 to learn more.

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Important Disclosures

This information does not constitute and is not intended to be a substitute for specific individualized tax, legal or investment-planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

Please read the Schwab Intelligent Portfolios Solutions™ disclosure brochure for important information, pricing, and disclosures relating to the Schwab Intelligent Portfolios and Schwab Intelligent Portfolios Premium programs.

Schwab Intelligent Portfolios® and Schwab Intelligent Portfolios Premium™ are made available through Charles Schwab & Co. Inc. (“Schwab”), a dually registered investment advisor and broker dealer. Portfolio management services are provided by Charles Schwab Investment Advisory, Inc. ("CSIA"). Schwab and CSIA are subsidiaries of The Charles Schwab Corporation.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Schwab wealth strategists and financial planners are employees of Schwab Private Client Investment Advisory, Inc., a registered investment advisor and an affiliate of Charles Schwab & Co., Inc.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.


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