When It’s Smart To Create a Tax Bill

When It’s Smart To Create a Tax Bill

March 30, 2024

Discover why embracing short-term tax bills can lead to greater financial gains in the long run.

When It’s Smart To Create a Tax Bill

March 30, 2024

We're in the thick of tax season. Paying tax is never popular, but as the April 15 deadline approaches, even the thought of creating a tax bill seems like blasphemy.

Our job at Old Peak Finance is to help clients achieve their financial goals. The key to affording those goals is maximizing each client's after-tax investment return without taking so much risk that a client can't sleep at night. And yes, I wrote after-tax.

But sometimes, it is wise to embrace a strategy that increases your tax bill in the short term to benefit you in the long run. Here are four classic examples.

Rebalancing.

The typical rebalance is to sell one type of investment (think, stocks) if it has risen significantly and buy another type (think, bonds) that has not risen as much, moving you back to a pre-agreed level of risk. A taxable brokerage account usually means creating a tax bill because you are selling the investments with the most gains. The cost is clear: a tax bill. But the benefit is usually worth the cost. By rebalancing back to your pre-agreed level of risk, you avoid being in a mix that is too aggressive, increasing the chance you will later sell stock in distress when the market falls.

Making Roth contributions or Roth conversions.

When you put money into retirement accounts as Roth dollars – either by contributing to a Roth IRA, making Roth contributions to your 401k, or converting some of your pre-tax (traditional) IRA into a Roth IRA – you create a tax bill. You are not obligated to contribute to retirement accounts as 'Roth.' In your 401k, you could contribute pre-tax dollars, which is the most common practice. Also, you could keep money in your traditional IRA until forced to take it out gradually as Required Minimum Distributions (RMDs), starting at age 73 or 75, depending on your birth year. But once money is in Roth dollars, whether in your employer-sponsored 401(k) or your Roth IRA, it grows tax-free forever and is withdrawn tax-free – and there are no RMDs. So, if you put money into Roth dollars today, while you're in a lower tax bracket than you'll be in when you withdraw later, it's better to pay tax now. It's not easier or more pleasant – but better.

Buying taxable bonds instead of municipal bonds.

Wall Street banks often invest their clients' bond portfolios 100% in municipal bonds, which pay interest-free of federal tax—and sometimes free of state or local tax, too. It sounds like a deal too good to pass up, but municipal bonds are not a good deal unless you are in or near the highest tax bracket.

The municipalities know you don't owe tax on their interest, so they offer lower interest rates. Most taxpayers are better off getting the higher taxable interest than the lower municipal bond interest. Even if you are in the highest bracket, it makes sense to diversify into some taxable bonds to avoid having all your eggs in one basket.

Selling some of the largest stock you own.

If more than 10% of your net worth is in any single investment, consider selling some of it. Often, that's your employer's stock, which is usually worth much more than the price you paid for it. Selling is painful for two reasons. First, it generates a tax. Second, it may have appreciated more than most of your other investments, so it feels like you should keep it or even buy more. But this is just another type of rebalancing. You are reducing risk. Especially if it is employer stock, you already have the risk of job loss, which usually increases as the stock goes down. Despite the tax bill, usually, selling some stock makes sense.

No one likes to pay more tax than they have to. But sometimes, creating a tax bill this year sets you up for greater wealth over the long term. Just as critically, it often reduces risks that can derail your financial plan.

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This article is not intended to provide tax, legal, accounting, financial, or professional advice. Readers should seek advice from qualified professionals who can review their specific circumstances. Old Peak Finance endeavors to provide information that is accurate and current. However, we cannot guarantee that this information has not been outdated or otherwise rendered incorrect by new research, legislation, or other changes. Old Peak Finance has no liability or responsibility to any individual or entity with respect to losses or damages caused or alleged to be caused, directly or indirectly, by the information contained on this website.

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