Tax season kicks off around the Super Bowl, so I’m usually popular with friends and family at game-day parties. I don’t expect that to change this year.
It’s not that my tax expertise enamors anyone. Most people aren’t interested in hearing about the 1,100-page tax bill I read throughout November and December. They simply want tips and techniques on how to pay less in taxes. I’m a taxpayer, too, so I want the same thing.
If you don’t have a friend or family member who can dish out tax tips over beer and wings at this year’s Super Bowl party, this blog (my introductory post!) is for you.
The power of planning
Being smart about taxes means planning for what you can control.
Filing details (due dates, tax rates and rules, etc.) may change, but you can always count on taxes. Every year, without fail, you have to file and pay your taxes. The sooner you accept this fact and focus on what you can control throughout the year, the better.
There are several tax strategies you can follow, but all of them usually share a common goal: to maximize how much of your money you get to keep.
According to a recent survey,* almost 37% of taxpayers planned to hire a professional to prepare their 2016 income taxes. Consulting with a tax professional can be a valuable experience—but waiting until it’s time to prepare your taxes means you’ve waited too long. You’ll benefit the most by making that call a few months before your taxes are due.
My friends and family always want to know what I do to manage my taxes. The simple answer I inevitably offer? I plan all year long. In the winter, I figure out my family’s income, investment returns, and tax-deferred contributions (among many other things!) from the preceding tax year. Then, every summer, I review our financial situation and forecast our year-end tax liability. I think about tax management all year, but I sit down and ask myself where we stand (tax-wise), at least a few times throughout the year.
Here are 3 questions you might ask yourself to maximize how much of your money you get to keep.
1. What type of retirement account should I use?
If you want to minimize taxable income right now, contribute as much as you can, up to the annual contribution limit, to a traditional IRA and a 401(k) plan. If you qualify for the deduction, the amount you contribute reduces your yearly taxable income, which could lower your tax bracket. You won’t have to worry about paying taxes as the account grows, but you’ll pay ordinary income tax on 100% of your withdrawals in retirement.
On the other hand, if you want to minimize taxable income in the future, and you meet the eligibility requirements, contribute the maximum amount you can afford to a Roth IRA, unless your income is too high to contribute directly. Then you might want to consider a backdoor Roth contribution by contributing to a traditional IRA, which has no income limits, and then converting that money to a Roth IRA later.
Does your employer offer a Roth 401(k) plan? If so, you might want to take advantage of it. Contributing to either type of Roth account won’t reduce your taxable income right now, but the account grows tax-deferred, and you won’t pay any taxes on the withdrawals in retirement.
If you’re not sure whether you’re going to jump into a higher tax bracket in the coming years (and truthfully, most of us—myself included—don’t know for sure), contribute to a traditional account and to a Roth, diversifying how your retirement assets are taxed now and how they’ll be taxed in the future. Diversification gives your portfolio the flexibility to manage unexpected changes to tax rules and personal circumstances.
Understand what options are available to you and make the most of them. For example, if you’re self-employed, you have more control over the type of retirement account you choose, the amount you contribute, and your contribution timing.
2. When should I cash out my taxable investments?
When you think of income, you probably think about the bottom-line figure on your W-2. But when it comes to managing your taxes, it’s essential to account for any investment income, too—including the gains you realize when you sell an investment in a nonretirement (aka taxable) account for more than you originally paid for it.
The taxation of your investment sale depends on how long you’ve held the asset you’re selling. For example:
- Long-term capital gains: Assets you’ve held for more than a year; taxed at 0%, 15%, or 20% (depending on your income threshold).
- Short-term capital gains: Assets you’ve held for a year or less; taxed as ordinary income.
The circumstances that require a withdrawal from a taxable account may be beyond your control. You may need to rebalance your portfolio or access money to purchase a new car. However, you may be able to control the timing of your withdrawals. You can:
- Make a large withdrawal in one transaction taxed in the same year.
- If you’re selling appreciated assets to rebalance your portfolio and you do it in one transaction, you can immediately reinvest the money to match your target asset allocation. On the other hand, you may generate enough capital gains to push you into a higher capital gains tax rate and trigger the 3.8% Medicare surtax.
- Break down a large withdrawal into multiple transactions taxed in different years.
- Using the example above, breaking up the transaction allows you to spread out the tax burden, lessening the chance of finding yourself paying a higher capital gains tax rate in any one year. You may even benefit from the 0% capital gains rate on a portion of your proceeds. But you’ll delay your ability to rebalance your portfolio back to the asset allocation that’s best suited to your goals, time frame, and risk tolerance.
- Sell assets at a loss—less than you originally paid—to offset gains.
- For this option to work, you need depreciated assets to sell. If you do have losses to “harvest,” think carefully before you act. Selling assets may throw off your asset allocation or jeopardize your ability to meet long-term goals.
You can control the timing of your withdrawals, but it can get complicated. (Cue help from a tax professional.)
3. Should I give to charity?
Before you use charitable giving to reduce your tax burden, consider your goals. Do you want to help a specific cause or organization? Do you want to contribute regularly (weekly, monthly, or annually) or build a charitable legacy for your heirs?
Claiming a tax deduction for a charitable contribution may reduce your taxable income for the year. (Under the new tax laws, you must time your charitable contribution carefully, and you may need to donate a significant amount to make itemized deductions more attractive than the expanded standard deduction.)
Before making a charitable contribution, consider your options:
- If you sell shares of stock or bond funds and direct the proceeds to a charity, the sale is subject to capital gains tax—which reduces the tax benefit of your gift.
- If you transfer shares of appreciated property (including investments) you’ve held for more than a year directly to a charity, you may receive a tax deduction—and you won’t have to pay capital gains tax. Donor-advised funds give you the option to “bunch” your charitable contributions and immediately claim a deduction, but you can make grants to charitable organizations over time. You can even allow the account to grow with the intention of leaving a charitable legacy for your heirs to direct.
- If you have to take a required minimum distribution (RMD), you can direct some (or all, up to $100,000 a year) of your distribution directly to a qualified charity, income tax-free. This may be an attractive option if you’re charitably inclined and your RMD, on which you pay ordinary income taxes, pushes you into a higher tax bracket, increasing your Medicare Parts B and D premiums, and affecting the taxable amount of your Social Security payments.
You can use any number of these strategies to manage your taxes, which makes planning especially important when you’re considering charitable giving. As with most deductions, there are strict limits on charitable contributions. At the risk of sounding repetitive: Discuss your options with a tax professional.
Invest more time in planning
Taxes are here to stay. Nobody likes paying them, and talking about them isn’t much fun either (even if the conversation takes place on the couch in front of the big game). Before you pay, ask yourself a few simple questions about your financial situation and take advantage of any opportunity to reduce your bill—you might even keep some extra money in your pocket.
Visit our tax center to get ready for tax season and get help for your most common tax questions.
*GOBankingRates polled 5,028 Americans on their tax-filing plans for tax year 2016.
Notes:
- All investing is subject to risk, including the possible loss of the money you invest.
- Diversification does not ensure a profit or protect against a loss.
- Tax-loss harvesting involves certain risks, including, among others, the risk that the new investment could perform worse than the original investment, and that transaction costs could offset the tax benefit. There may also be unintended tax implications.
- When taking withdrawals from an IRA before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax.
- We recommend that you consult a tax or financial advisor about your individual situation.
