Have the right types of accounts. Match asset and account types well. Withdraw funds from different accounts in the right order.
Whether your investments go up, down or sideways, there’s much you can do to spare your assets from U.S. taxes.
Three key pillars of what we call “tax-aware wealth management” are simply to make sure that you:
- Have the right types of accounts
- Put the right assets in the right accounts
- Withdraw from those accounts in the right order
These fundamental but highly effective ways to save on U.S. taxes are well worth your attention as you create new accounts and/or take a moment to tidy the accounts you already have.
1. Have the right types of accounts
If you make no other arrangements, your assets are likely to be held in some kind of “taxable account,” i.e., taxes will be due annually on the realized growth and income of the account’s assets.
So, the first step (no matter your age) is to make sure you take advantage of any retirement accounts available to you to get the benefits of tax-deferral. Next, those who have sufficient wealth and a desire to give to the next generation should look into trust accounts—which can help reduce and potentially even eliminate the transfer taxes on your estate.
If you’re employed, company-sponsored plans such as 401(k)s offer the opportunity either to defer taxes or, in the case of Roth 401(k)s, even generate tax-free growth. Such plans frequently offer another benefit: a company contribution, or match, based on a percentage of the amount you’ve contributed (up to a salary cap). These matches are essentially free money for you.
Next, consider contributing pre-tax dollars to a traditional IRA up to the limits allowed under law. Also, if your higher income levels necessitate it, consider making after-tax contributions.1 But beware: If you’re making after-tax contributions, you’ll need to take extra care in how those dollars are invested or ultimately used so you don’t end up in a worse position than had you done nothing.
Depending on your situation, your after-tax contributions to a traditional IRA might be great candidates to convert to a Roth IRA. This strategy—often called a “back-door Roth IRA”—typically makes the most sense for people who don’t have large IRA balances due to the “aggregation rule."2
For those who have large retirement accounts filled with pre-tax dollars, now may be a good time to consider converting their traditional IRAs into a ROTH. That move essentially means you’ve decided to pay the embedded income tax lability on those assets. But it also means that, going forward, you can let those assets enjoy tax-free growth and you will pay no taxes on the assets when you withdraw them.
Converting now from a traditional to a ROTH IRA may make a lot of sense given that the today’s top rate of 37% is scheduled to increase in 2026 to 39.6%.3
If you have the desire and capacity to make large gifts to your children or grandchildren, you might want to use your lifetime gift tax exemption as soon as possible. This action moves the gifted assets (and their growth) out of your estate and beyond the reach of estate taxes (aka transfer taxes). In 2023, the exemption amount is $12.92 million per person.
Of course, you could make this gift outright. However, for a variety of reasons (including your ability to set the terms of the assets’ management, investment policy and distribution) it’s often wiser to put these assets into an irrevocable trust―naming whomever you like as the trust’s beneficiaries.
If you then pay income taxes due on the trust asset’s growth, you’d be both increasing the amount you move out of your estate and providing more for your beneficiaries. Note: these payments do not count as additional gifts and allow the trust to grow without income tax consequences for your beneficiaries.
If you don’t want to make a large gift or have already exhausted your lifetime gift tax exclusion amount, you might want to consider creating a Grantor Retained Annuity Trust (GRAT).
A successful GRAT passes to your named beneficiary, or to a trust for their benefit, any appreciation it manages to generate above the Internal Revenue Service hurdle rate in effect when you created the GRAT. During the GRAT’s term, you will retain the principal via annual annuity payments with a small amount of interest.
To increase the likelihood of the GRAT’s success, consider putting into it depressed assets that are likely to rebound.
2. Put the right assets in the right accounts
Where you put your assets can make a significant difference on how much you pay in taxes over time. Our analysis finds that it is often far wiser to put into your:
- Tax-deferred (aka retirement) accounts all those “tax-inefficient” investments that generate a lot of ordinary income via interest and short-term capital gains. This includes high-turnover equity portfolios, high-yield and investment-grade bonds, some hedge funds and real estate investment trusts (REITs)
- “Taxable accounts” (i.e., taxes are due annually on the assets’ realized growth and income) all holdings that can be described as “tax-efficient” because they predominantly generate returns taxed as qualified dividends or long-term capital gains. Such investments include low-turnover equity funds and SMAs and private equity
Also consider your time horizon when selecting which investments to put in which account types.
For example, if you have short-term outlays (such as a large tax payment from a business sale, new vacation home or yacht purchase), consider a liquidity account invested in short-term cash-like instruments.
Your time horizon and therefore your investment decisions may be very different if you’ve already used your lifetime gift tax exclusion amount, perhaps by contributing to a Spousal Lifetime Access Trust (SLAT).
Technically, a spouse is the “current beneficiary” of a SLAT. However, if there’s a low likelihood that the funds in this trust will ever be needed (or at least not needed for a very long time), the overall allocation of these assets likely should be more growth oriented. The compounding effects over 20, 30 or 40 years could be meaningful for the trust’s “remainder” (ultimate) beneficiaries.
3. Withdraw from your accounts in the right order
Also keep taxes in mind when you are making withdrawals from your accounts.
If you’re subject to the top income tax rate, our general guidance would be to withdraw from your accounts in this order:
- IRAs (for your required minimum distributions)
- Taxable accounts (such as joint or individual accounts and revocable trusts)
- Tax-deferred accounts (traditional IRAs)
- Tax-free accounts (Roth IRAs)
If you are not in the highest income tax bracket, your optimal withdrawal hierarchy may be more nuanced. It might make sense for you to tap into your tax-free accounts (Roth IRAs) before touching your tax-deferred accounts―if that means you’ll avoid pushing yourself into a higher income tax bracket (which could have a negative ripple effect on your other income sources, such Social Security, rental income or a pension).
If you are the beneficiary of any irrevocable trusts, unless distributions are mandatory, consider avoiding requesting distributions, as these assets are likely already out of your estate. If you have assets still in your estate, it often makes sense to spend those down first.
Finally, if you want to give to charity at your passing, consider earmarking your tax-deferred accounts for this purpose. Charites are tax-exempt; they do not have to pay any income taxes on these assets (unlike your human beneficiaries).
We can help
It’s not enough just to know the various account types, investment considerations and withdrawal strategy. Your tax status over time, estate-planning goals and charitable giving intentions all factor into your overall financial success.
Your J.P. Morgan team can help you think through all these decisions to ensure you make the most of your resources. Reach out to them today.
1In 2023, you can contribute up to $6,500, or—if you were 50 years or older, up to $7,500 of your earned income to a traditional IRA or a Roth IRA. Traditional IRA contributions are pre-tax except when adjusted gross income exceeds certain thresholds. In this case, contributions are made after-tax and are non-deductible.
2The aggregation rule for IRAs states that when you convert one traditional IRA, the IRS considers all your traditional IRAs as a single total IRA to determine how much of the conversion is taxable. If you have deductible and non-deductible money in one IRA, and deductible money in another IRA, conversions must be pro rata across both IRAs, making the conversion a taxable event for potentially more than you may expect if you are converting the IRA with both deductible and non-deductible money.
3The current 37% rate, which went into effect as part of the 2017 Tax Cuts and Jobs Act (TCJA), applies to taxable income above $578,125 for individuals and $693,750 for married couples. Many higher-income earners may find themselves moving relatively quickly into higher brackets in the coming years. That’s because the TCJA changed the method by which the government will calculate inflation, which is used to make adjustments to the income levels for the brackets.