Retirement Weekly: Tax planning for long-term investments in an era of uncertainty

We’ve experienced a lot of market volatility over the last couple of years, which affects not only our current financial plans but also our long-term investments and retirement goals. Navigating uncertainty around inflation and taxes can feel overwhelming, but it’s wise to consider preparing your financial assets for unpredictability in the market and get ahead of possible impacts on your portfolio.

I always recommend that my clients seek out investments that minimize taxes, such as retirement plan investments, home mortgage interest, charitable contributions, college funds, and health savings accounts. But aside from ensuring you’re participating in plans and programs with tax and retirement savings, here are a few ways to protect your long-term finances in an unpredictable market, especially in a COVID-19 era:

1. Consider opening a backdoor Roth IRA

The backdoor Roth IRA allows high-earning individuals and couples to put money into a Roth IRA for future tax-free savings that are not subject to Required Minimum Distribution requirements. While there is not an immediate tax benefit, you’ll be able to take advantage of tax-free growth for the future—and I’ve had several clients utilize this strategy to save more money on a tax-free basis. 

The backdoor Roth IRA is designed for those that have exceeded the current IRS limits for direct contributions to a Roth IRA. Because there is not currently an income limit to contribute to a nondeductible traditional IRA, and there are no current limits that restrict an individual/couple from converting as much of a traditional IRA to a Roth as they like, this “backdoor” strategy presents a significant opportunity for tax savings.

To take advantage of this strategy, investors fund up to the IRS limit into a nondeductible traditional IRA. Because it is nondeductible, there is no immediate tax benefit, but once you “convert” this nondeductible traditional IRA to a Roth IRA, there is no tax due on the full contribution amount. Once this conversion is complete, you’ll have effectively funded a Roth IRA and will benefit from future tax-free growth and earnings.

Keep in mind that if you are under age 59½, there is a five-year rule that requires funds from a converted Roth to remain in the account for a minimum of five years. Otherwise, you may be subject to an early-withdrawal penalty.

2. Weigh the benefits of downside protection investments

In volatile market conditions, it can be wise to add investments to your portfolio that provide some element of downside protection. This buffer will protect your assets in the event of an economic downturn.

In truth, downside protection investments can be an essential component of any healthy portfolio—whether there’s significant market volatility or not. Financial advisers often incorporate downside protection investments into financial plans to ensure stability for important assets no matter what’s happening in the economy.

3. Be aware of the Alternative Minimum Tax (AMT)

Anyone with gross income over the AMT exemption amount must run the AMT calculation to see if they are subject to the tax. For 2021, this is $73,600 for singles and $114,600 for married couples filing jointly (NerdWallet). Historically, the majority of AMT is paid by taxpayers with incomes over $1 million.

If you’re subject to the AMT, here’s how to reduce its potential impact:

  • Maximize contributions to tax deferred retirement plans, health savings accounts, flex spending accounts and tax deferred compensation plans if available 

  • Utilize tax-efficient investments (ETFs/mutual funds) and/or tax-exempt vs taxable bonds in your nonretirement investment portfolios 

  • Maximize your donations to charity to help reduce your Adjusted Gross Income

4. When in doubt, ask an expert

Certain tax policies and unpredictable shifts in the market may inevitably affect your financial planning. If you’re unsure how you’ll be impacted or what steps to take next, consider reaching out to a financial adviser.

Financial advisers can be a valuable resource for up-to-date information on complex, shifting policies. They can especially help you decipher:

  • Tax rates: Depending on how tax rates shift in 2022, you might be affected by changes to both corporate and individual taxes. This could have a major impact on economic growth, personal income taxes, small business taxes and capital-gains taxes.

  • Interest rates: As interest rates fluctuate, the cost of borrowing could impact your ability to borrow for a new home, business, college education or other significant investment. A financial adviser can help you anticipate these rate changes and make a plan that aligns with your long-term goals.

As policies, tax rates, and inflation impact the market, your financial plan may change. Flexibility is key, and if you’re open to adjusting your approach, your goals will remain within reach even in the face of market volatility. Powerful, short-term adjustments could protect your financial goals in the long-term.

Faron Daugs, CFP, is founder and chief executive of Harrison Wallace Financial Group.

This post was originally published on Market Watch

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