Tax-saving tips

I list some legal tax-saving tips that I learned over the years.

HSA

With an HSA (Health Savings Account), you can contribute up to $8,300 in 2024 as a family and deduct the amount from income. The investment grows tax-free. You can then spend the fund for qualified healthcare expenses such as medical/dental bills and drug prescriptions. As healthcare expenses are exorbitant in the U.S., HSAs relieve part of the pain.

Retirement accounts

There are employer-sponsored accounts such as 401b/457b and individual accounts (IRA). Both have similar functions and you can use either traditional or Roth accounts. With traditional, you invest pre-tax and pay taxes when you withdraw the funds during retirement. With Roth, you invest after-tax and withdrawals are tax-free. There are two considerations for choosing between traditional and Roth.

1. If you are in a high (low) tax bracket now but expect to be in a low (high) tax bracket in retirement, traditional (Roth) may be better. But it is difficult to predict future tax rates. Diversifying between traditional and Roth may be a good idea.
2. If the tax rates between now and the future are the same, then Roth is strictly better than traditional. This is because (a) Roth does not have required minimum distribution (RMD), so it is more flexible, and (b) because the nominal contribution limits of traditional and Roth are the same, Roth allows larger investments in terms of after-tax dollars. (E.g., if your marginal tax rate is 33.3%, investing $10,000 to traditional pre-tax is equivalent to investing $6,666 to Roth after-tax. In this example, the contribution limit of Roth is effectively \(1/(1-0.333)=1.5\) times larger than traditional.)

Roth conversion

If you already have traditional retirement accounts, you can do a Roth conversion any time. But it is important to decide the amount and timing of Roth conversion.

1. Regarding the amount, because funds in traditional accounts are tax-deferred, you need to pay income tax on the entire conversion amount. Thus, it is best to estimate your tax bracket towards the end of the year and convert funds so that you stay in the lower tax bracket.
2. Regarding the timing, if possible it is best to do a Roth conversion during a market downturn, because that way you generate less income for the same number of shares converted.

Backdoor Roth

Although there is an income limit for Roth IRA contribution, you can get around it by using the loophole known as “backdoor Roth”. It works as follows.

1. During the year, contribute to traditional IRA ($7,000 in 2024).
2. During the same year, convert traditional IRA to Roth.

See here for a good explanation.

Donate appreciated stocks to kids

If you have kids (that can be trusted), you can save taxes by donating them appreciated stocks. Here is why.

1. If you are a married couple filing jointly, you can donate up to the annual exclusion limit of $36,000 without paying gift tax.
2. However, if you gift stocks, the recipient inherits the cost basis of the donor, so there will still be capital gains if the investment is sold. Currently, a child’s unearned income (e.g. capital gains) of more than $2,600 is taxed at parents’ rate (see here).
3. Therefore, as long as you donate stocks with capital gains up to $2,600 and assuming the child has low income, there will be no capital gains tax. Thus, if you trust your kids, you can donate appreciated stocks with capital gains up to this limit, let them sell the investment, and then ask them to pay the bills.