… but when it does pay off, the reward can be substantial.

By Rick Waechter, Founder

We are heading into Q4, and people will be thinking about what they can do to minimize their 2025 tax bill.

There are usually several steps you can take, and we will remind our clients what may make sense for their unique situation. That may include a large charitable gift, using their retirement account to make a qualified charitable distribution (QCD), tax-loss harvesting or bumping up their retirement contribution.

But the most lucrative tax strategies are different. They are more complex. They almost always take years to play out. Sometimes there is an up-front investment. Sometimes you face a risk that the strategy may fail. But in all cases, the benefit can be significant. If you haven’t thought through them, there is no time like the present to start.

Some of the best strategies are below. This is Part 1 of a 2-part blog. Part 2, next week, will outline more strategies.

If You Are Working: Mega Backdoor Roth Contribution

• Background: Money contributed to Roth retirement accounts -- IRAs and 401(k)s – grows tax-free for your entire life, with no requirement to distribute it and no tax when you do withdraw. That’s different from a traditional retirement account, where annual withdrawals are required after a certain age (75 for most people) and those withdrawals create taxable income. But there are limitations on Roth contributions. Annual Roth IRA contributions are capped and not allowed if your income is above a threshold that eliminates high-income earners. For high earners, the only way to move significant money into a Roth account is by converting money from a traditional retirement account, creating an immediate tax bill.
• Strategy: Contribute the annual max to a Roth 401(k) through a so-called Mega Backdoor Roth Contribution. Many 401(k) plans now allow an employee to contribute after-tax dollars on top of their regular 401(k) deferral into a Roth 401(k) account. This is technically a 2-step process: contributing after-tax money to your 401(k), then doing an in-plan conversion of that money to a Roth account. A high earner can typically contribute about $40,000 annually, and there is no income limitation.
• Downsides: Cash that you cannot access for at least 5 years, and preferably for decades. No up-front tax benefit.

If You Receive Restricted Stock Compensation: 83(b) Election

• Background: When you receive stock compensation – restricted stock or unvested options – you only pay tax when the shares vest and, in the case of options, when you exercise the options, converting them into shares. You and the company hope the shares will be worth more at that time. The downside: your tax bill is based on that later value, and vesting or options exercise is treated as ordinary income, not as capital gains income, which has a lower tax rate. By contrast, if you owned the shares outright and sold at a higher price later, all the gain would attract capital gains tax treatment.
• Strategy: The 83(b) tax provision allows you to pay tax on receipt of the restricted stock award, at what you hope will be a lower price than at vesting. All appreciation above that price becomes capital gain.
• Downsides: An 83(b) election must be made within 30 days of receiving the stock grant, which is often missed by employees. If you leave the company before vesting or if the company’s share value goes down, you will have paid a higher tax than you would have otherwise owed in the future.

If You Are Nearing Retirement: Plan for an Income Desert and Use It to Create No-Tax or Low-Tax Income

• Background: Many people who retire in their early to mid-60s may have little taxable income until they claim a Social Security benefit, assuming they have no pension or a working spouse. They will not be required to withdraw from their traditional 401(k) or IRA until age 73-75, depending on year of birth. Some people will need their Social Security check to cover living expenses. But others may have a significant investment or bank account from which they can spend.
• Strategy: Defer your Social Security benefit, preferably to the latest date (age 70), and use funds in your brokerage account to cover expenses, taking advantage of your lower tax bracket.
  • If you are in the first two tax brackets, capital gains are tax free. So, when you sell investments, you may owe no federal tax. By contrast, when you start taking your Social Security benefit and withdrawing from your retirement plans, capital gain will be at the normal federal rates of 15-20%.
  • If you have a large pre-tax retirement account, you can withdraw some of it at a lower tax rate than you might have in your 70s and 80s, or convert it to a Roth IRA, paying tax now on the conversion amount. That is tax you or your heirs would otherwise have to pay later.
  • When you claim Social Security later than your normal retirement age, you will lock in a higher monthly paycheck for the rest of your life. If your spouse outlives you, he/she will be entitled to that higher benefit when you pass away.
• Downsides: You may not be able to afford to live without the Social Security benefit, or this strategy may create no tax advantage because investment and other income is so high that you will never have an income desert, even before claiming Social Security.

If You Own Mutual Funds Which Pay Large Capital Gains Distributions Annually or Hedge Funds with High Turnover-Related Tax Bills: Sell and Replace with Tax-Efficient Funds

• Background: Mutual funds which trade frequently – and virtually all hedge funds, since they are active traders – typically pay out a large end-of-year, taxable capital gain distribution. This is your share of the fund’s capital gains from trading, even if you did not sell your shares in the fund. This does reduce the capital gain tax you will pay later when you sell, but it puts the fund – not you – in control of the tax bill timing. Some mutual funds pay annual capital gain distributions of 10% or more of the fund’s value. That’s all taxable.
• Strategy: Analyze any holding which pays a distribution of 5% or more annually. Look at the unrealized gain in your shares. If the unrealized gain is meaningfully less than your expectation for the annual capital gain distribution multiplied by the number of years you may hold it, sell, pay the tax, and replace the position with a more tax-efficient holding. Most exchange-traded funds (ETFs) and passive mutual funds (including index funds) pay no capital gains distribution.  
• Downsides: An immediate tax bill, which can be large.

If You Can Take Significant Investment Risk: Place High-Potential, High-Risk Investments in a Roth IRA

• Background: Money in a Roth account will never be taxed during your lifetime. If your kids inherit it, they will have to withdraw it within 10 years – like any inherited retirement account – but the withdrawals will be tax-free. This is the optimal account to own investments which have the highest growth potential. A high-growth investment held in a taxable account will owe capital gains tax on the sale, and in a pre-tax retirement account, the proceeds will eventually be distributed at ordinary income tax rates, which are usually the highest brackets. Venture capitalist Peter Theil is rumored to have bought shares in early-stage companies in a Roth IRA, which eventually became worth $5 bn. Whether this is true, the strategy is sound.
• Strategy: Use your Roth IRA to invest exclusively in stock and other investments with high growth potential. If you want to buy early-stage, private investments, you may need to open a self-directed IRA, which is a hassle and more expensive – but potentially worth the trouble.
• Downsides: A billionaire like Peter Theil can afford to make very high-risk investments, because if one or a few investments provide no return, he will still be fine financially. That may not be your situation, so tread carefully.

If You Own or Invest in Early-Stage Companies: Use the QSBS benefit

• Background: Most company founders and their earliest investors hope for a large payout when they eventually sell the company, often years later. That gain is subject to capital gains tax. Congress created the Section 1202 qualified small business stock (QSBS) tax benefit to incentivize entrepreneurship. There are limitations, but many early-stage companies can be structured so that early investors will owe no tax on significant gains when they sell the stock.
• Strategy: Founders must incorporate as a C Corporation, a requirement for your shares to be QSBS-eligible. Investors should identify opportunities which are QSBS-eligible. There are limitations on company size and on the amount of eventual gain which can be tax-free. Some company founders multiply the benefit to avoid this limitation by spreading share ownership among family members, partnerships, and trusts. For example, if an owner and her sister each own QSBS stock, they double the potential tax benefit. If an owner sets up irrevocable trusts for kids and transfers shares to those trusts, that similarly multiplies the potential tax benefit.
• Downsides: When you establish the company, it must be a C Corporation to obtain the QSBS tax benefit. Creating a C Corporation is a hassle, it’s expensive, and you have added another layer of income taxation. Most early-stage companies are LLCs or partnerships and often file as S Corporations, which is easier and not subject to the additional layer of tax.

If Your Estate May be Taxable When You Die: Gifting Stock or an Asset Expected to Grow Substantially to an Irrevocable Trust

• Background: Anyone who passes away with a net worth over $15 mm will owe federal estate tax of 40% on the surplus. That exemption is much higher than historically. Many people with lower net worths could reasonably worry that the exemption could be lowered and impact them when they die. For example, in the late 1990s, the estate tax exemption was $600,000. Anything someone gives away during their lifetime, above a modest annual gifting limitation, reduces the $15 mm exemption dollar-for-dollar. But once an asset is outside of your estate, the growth will, by definition, not be subject to estate tax when you die.
• Strategy: Create an irrevocable trust benefiting your kids or grandkids, contribute to it, and then buy stock or other investments you expect will appreciate substantially over a long period. You can also contribute investments you already own which have unrealized gain. Since the trust may not be tapped for decades, you can take significant risk in the investments. An illustration: You contribute $1 mm of appreciated stock to the trust, using $1 mm of your estate tax exemption. But if the asset grows to $4 mm at your death, you sheltered the $3 mm in growth from estate tax.
• Downsides: You lose control and use of anything you give away. What if you need that money later? What if you later determine you don’t like how the trust beneficiaries may use the trust’s assets? The Form 709 gift tax filing is a hassle. The trust will owe tax at the highest tax bracket, so you need to minimize its annual income. You lose the step-up at death you would have achieved if you had held the asset until your passing.

Next week: more attractive strategies to minimize your lifetime tax bill.