It’s Tax Season: Let’s explore various planning strategies

It’s Tax Season: Let’s explore various planning strategies

By: Scott Adair, CFP®, Wealth Management Advisor

We are in the heart of tax season with the filing deadline quickly approaching (April 15th). With this in mind, now is a great time to bring to the forefront a variety of year round tax planning strategies that can help you (and your wallet) prepare for tax season year in and year out.

By incorporating some of these strategies, our clients have been able to retain more of their hard earned money by paying only the necessary amount of taxes each year.

Below we have outlined six strategies that could potentially help lower your tax bill, depending on your unique situation. As always, consult a CPA to determine your specific needs based on your circumstances.

Maximize retirement account contributions – If your employer offers a retirement plan (like a 401(k)), maximizing your annual contributions is not only a great way to grow your retirement assets tax-deferred, but you also get an immediate tax benefit. Contributions to your 401(k) are pre-tax and are deducted from your taxable income. 401(k) contribution limits are $19,000 (plus a $6,000 catch-up amount if you are age 50 or older).

You might also be able to reduce your taxable income by contributing to a Traditional IRA. If your modified adjusted gross income (MAGI) is $64,000 or less per year and you are single, you can deduct the full contribution. If you are married, it gets a little more complicated. You can deduct the full contribution if you and your spouse are not covered by a retirement plan at work. If you are covered by a plan at work and your MAGI is $103,000 or less, you can deduct the full contribution. If one of you is covered and one of you is not, your MAGI needs to be $193,000 or less for the full contribution to be deductible. IRA contribution limits are $6,000 (plus a $1,000 catch-up amount if you are age 50 or older).

Double up on deductions every other year – Also known as “deduction bunching,” this strategy requires that you take a two year outlook on your taxes. The new tax law that took effect in 2018 doubled the standard deduction to $12,000 for individuals and $24,000 for married couples filing jointly. The new law also capped the amount of total deductions that you could take for property, sales and state income tax to $10,000 in aggregate. This change means that fewer people will itemize deductions on their tax return every year, since most people will not have deductions that exceed the new increased standard deduction. However, there could still be opportunities to maximize deductions by alternating every other year between itemizing and using the standard deduction. For example, if you know you are going to make a large charitable donation to a charity, and you also have upcoming elective medical procedures, you could group these in the same year. This especially makes sense if these the total of these deductions gets you considerably over the standard deduction limit. For years that you do not have large deduction opportunities you would just use the standard deduction.

Roth IRA Conversions – Roth IRAs are treated differently than Traditional IRAs from a tax perspective. Contributions to Roth IRAs are not tax deductible, but distributions in retirement are not taxed. The opposite is true with Traditional IRAs. Contributions are tax deductible, but distributions are taxed at your ordinary income rate in retirement. One option Traditional IRA owners have is converting a portion or all of their IRA holdings to a Roth IRA. The conversion amount must be picked up as ordinary income, but depending on your current tax bracket, this might be a good strategy. For example, let’s say you are 60 years old, you have just retired so you do not have W-2 income, and you have $500,000 in a Traditional IRA. You will not have to start taking taxable required minimum distributions from your IRA until age 70½. Also, if you have decided to defer taking Social Security benefits until age 70 to get an increased monthly benefit. This scenario creates a 10 year window in which you could be in a lower tax bracket than when you reach age 70. This is the perfect opportunity to convert some of your Traditional IRA assets to Roth at a lower tax rate. While you do have to pick up the conversion amount as income, once the assets are in your Roth IRA you will never be taxed on them again. Just be sure you do not convert too much and bump yourself up into a higher tax bracket. You can no longer “unwind” or correct the amount you converted. ML&R Wealth Management Advisor, Carli Smith, will explore Roth IRA conversions in greater detail in an upcoming newsletter.

Qualified Charitable Distributions (QCD) – At age 70½ IRA owners can donate up to $100,000 a year to a qualified charity, directly from their IRA. Spouses can also donate up to $100,000 a year from their own IRA. QCDs satisfy the Required Minimum Distribution that kicks in at age 70½, and the distribution does not get included as income. For example, let’s say a married couple usually donates $10,000 a year to a qualified charity, and that their annual RMD amount is also about $10,000. Since the standard deduction is now $26,600 for people age 65 and older, the couple may not itemize deductions if their total itemized deductions are less than the standard deduction. If the couple writes checks directly out of their IRAs to the qualified charity, they will get the benefit of reduced AGI by donating their IRA distribution rather than having to capture it as income on their return. They will also get the benefit of the $26,600 standard deduction.

Tax Loss Harvesting – While we do not like it when the stock market declines, we do like to take advantage of capital losses when it makes sense. If you own a mutual fund that has declined in value, you can sell it and buy a similar fund to replace it. You can use the capital loss you just “harvested” to offset capital gains and up to $3,000 a year in ordinary income once you have offset all of your capital gains. Capital losses can be carried forward indefinitely. One thing to be careful of, the IRS will disallow the loss you just harvested if you buy the same asset that you just sold within 30 days of selling it.

Asset location – If you have a combination of taxable brokerage accounts and tax-deferred retirement accounts (IRAs, 401(k)s), it is good to pay attention to where the different types of assets that you own are located. To the extent that you own bonds and REITs, which generate taxable income at your ordinary rate, those assets should be owned in tax-deferred accounts. You do not pay taxes on income generated in tax-deferred accounts until withdrawal. Assets that are expected to appreciate faster, like stock mutual funds, should be placed in taxable brokerage accounts. Although interest and dividends that are generated from stocks are taxed at your ordinary rate, they generate less taxable income than bonds and REITs. Also, when you sell the stock mutual funds you receive the more favorable capital gains rate of 15% (or 20% for people in the top tax brackets), as long as the assets were held for over a year.

In conclusion, though this is the time of year we are most focused on taxes, it is important to remember that effective tax planning can be practiced year round. Always keep good records of any taxable events throughout the year, for example selling property or exercising employee stock options. Also, if you receive income in which taxes are not automatically withheld (self-employment or S corporation shareholders for example) you may need to make estimated quarterly tax payments in order to avoid an IRS penalty. If you are unable to file your taxes by April 15th, you can apply for a six month extension (you still have to pay taxes owed by April 15th to avoid penalties and interest).

At ML&R Wealth Management, we like to remind our clients that at the end of the day, it is not what you make but what you get to keep that is important. With a careful review of your tax situation, and by implementing some of the strategies mentioned above, hopefully you can keep more of the money that you earn.

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