Tax Planning - All Year LongSubmitted by Affiance Financial on August 31st, 2015
by Seth Meisler
“The only difference between death and taxes is that death doesn't get worse every time Congress meets.” – Will Rogers
If you missed my April 14 “Coffee Chat”— we served a pretty good lunch —you still have time to get in on the game. Even though my theme focused on it being time to start planning for 2015 taxes, rest assured it’s not too late.
Your tax return tells a story
First, consider the narrative provided by your tax return. While initially it might appear to be boring pages of numbers, a closer look can reveal:
- Details of your cash flow. You can find out your income, taxes, savings into an IRA—and you can “back into” your expenses. If you itemize deductions, you might find health care expenses and charitable contributions as well.
- Information important to your investment, retirement and estate-planning strategies. For example, you can find information about the activity of your taxable accounts such as capital gains/losses, dividends, and interest.
- Overlooked opportunities to help you achieve your financial goals. For example, could you invest in a Roth IRA or convert a Roth IRA? Are there additional deductions available?
Now you can take this information and weave it into your financial story.
- Using the tax return plus your savings accounts statements—including your 401(k) and taxable accounts—you can also estimate how much you are spending using the following formula:
= You spent the rest!
So, how can tax planning serve as the bridge to financial planning? It can help you:
- Think about taxes year-round
- Save money in a tax-efficient manner for future needs
- Spend money in a tax-efficient manner so you keep more to invest in your future
What was new in 2014?
In 2014, Congress implemented the 3.8% net investment income tax (unearned income Medicare contribution tax). The 3.8% tax applies to dividend income, interest income and capital gains taxes for higher earners. The tax becomes effective when modified AGI (adjusted gross income) is above $250,000 for married couples and $200,000 for singles.
Also, instead of raising taxes, Congress has essentially adopted a strategy of using “phase-outs” of personal exemptions and itemized deductions. By reducing deductions and exemptions for high earners, Congress effectively raised taxes—potentially increasing rates by as much as 2.3%.
Tax bracket investment strategies
Based on your marginal tax bracket, you will want to consider an investment and tax strategy that is appropriate for your situation and will save you taxes.
10%-15% tax bracket. You are in one of the lowest tax brackets. Therefore, there is less concern about taxable income. In fact, in some situations, you may be better off taking the income now due to your low tax bracket and 0% tax on capital gains and qualified dividends.
25%-33% tax bracket. Your tax bracket is higher and thus you need to focus more on tax deferral because your taxes will likely be lower in the future, when you are no longer working. Ideas include contributing to:
- Tax-deferred IRAs
- 401(k) plans
- 403(b) plans
33%-39.6% tax bracket. You are in the higher or highest tax brackets. As such, planning becomes more complicated and there is more of a need to focus on tax strategies, looking for places to defer income. These could include:
- Roth IRA conversions
- Non-deductible IRA contributions
- Tax-exempt interest
- Life insurance
Tax planning strategies for the future
Finally, tax planning can play a significant role in planning for the future, especially when leaving a legacy to children and grandchildren. Of course, Congress will undoubtedly change tax laws again in the future (as duly noted by Will Rogers) but you should strive to do what makes the most sense for you under the current law.
Here are some options to consider:
Strategic gain/loss harvesting
Income-shifting to future generations - This is a strategy based on the premise that your children's and grand children's tax rate will be lower than yours, so it makes sense to move the income forward through gifting strategies.
Maximizing 401(k) plans and traditional IRAs - These are tax-deferred vehicles that allow you to deduct the taxes when you contribute and pay the taxes upon withdrawal.
Charitable Giving - If you have a desire to give to charity, creating a charitable trust or a donor-advised fund can be a tax-management strategy. For instance, you may know you want to leave a legacy to charity, and you currently are earning more than you expect to in retirement. You can create a donor-advised fund and put money into it now, to be given away later.
One useful way to put money into a donor-advised fund is to use appreciated stock. You move the stock into the fund, avoid any capital gains tax, and receive the tax deduction. The deduction is more valuable to you now than it would be later and you will have money to give away even when you are no longer working.
Social Security - There are a number of strategies for taking Social Security, which are beyond the scope of this article. Suffice it to say that you should carefully research this topic before making a decision about when to start drawing your benefits, especially if you are married (or have access to a former spouse’s benefits). Read more about taking Social Security elsewhere in our newsletter.
Timing of income to fill up tax brackets - If you have the possibility of controlling income through stock options, deferred salary, Social Security or IRA distributions, you may want to take some of that income sooner rather than later.
Conventional wisdom has always been to defer income. However, it may be more desirable to move income sooner because your tax rate today may be lower than it will be in the future, thus lowering your overall tax bill. The timing of income includes considering a Roth IRA conversion.
Asset location - This involves thinking about whether assets are located in the most tax-efficient accounts. For example, bonds that pay interest income that is taxed at ordinary tax rates may be better off being held in tax-deferred accounts, as opposed to taxable accounts or even Roth accounts, which are tax-free.
Educational planning for children and grandchildren - There are several options here, including Education IRAs (which allow you to pay for primary and secondary schooling) and 529 plans, which move money outside of your estate and allow it to come out tax-free for post-secondary education.
Tax-deferred annuities - These defer taxes on any growth in your investments until you begin taking withdrawals, allowing for compounded growth. Withdrawals are taxed at ordinary income tax rates.
As you can see, tax planning really is a year-round endeavor. Bur rest assured, regardless of how much planned - or didn't plan - you will have to think about it all over again in April!