Whether you are working and receiving W-2 wages as your primary source of income, or you are retired and using portfolio withdrawals or fixed income to meet your spending needs, there are several tax planning strategies that could be worth exploring. Tax planning strategies are not one size fits all though. Careful consideration of your personal tax circumstances is important before following any of the recommendations you might read here or elsewhere.
- Maximize Retirement Savings
Maximizing annual deferrals to an employer retirement plan is not only a great way to grow your retirement assets tax-deferred, but you also get an immediate tax benefit by reducing your taxable income by the amount you defer. For 2023 tax planning, the maximum deferral amount to a 401(k) is $22,500 (plus $7,500 catch up for age 50 and older).
Depending on your circumstances, you might also be able to reduce your taxable income by contributing to a Traditional IRA. If you (or your spouse if married) are not covered by an employer retirement plan, you can deduct the full amount of your IRA contributions from your taxable income. Married couples with one spouse who is covered by an employer retirement plan can deduct the full amount of their contribution if their modified adjusted gross income MAGI is $218,000 or less. If both spouses participate in retirement plans at work, a full deduction is available if your MAGI is $116,000 or less. Single tax filers who are covered by an employer retirement plan can deduct the full IRA contribution amount if their MAGI is $73,000 or less.
- Health Savings Account Contributions
If you are enrolled in a qualified high deductible health plan with no other coverage that disqualifies you, consider contributing to a Health Savings Account (HSA). HSAs are a type of personal savings account used to pay medical costs. Contributing to an HSA provides a potential triple tax benefit, because contributions are tax deductible, HSA assets grow tax-free, and distributions are not taxed if used for qualified medical expenses. If money in an HSA is not used for qualified health expenses, there is a 20% penalty (for those under age 65) plus the distribution is taxed at your ordinary income tax rate. Once you are 65, you will owe taxes on the distribution but not the 20% penalty. Health Savings Accounts are portable, and you remain the account owner regardless of employment changes. The HSA contribution limits for 2023 are $3,850 for individuals and $7,750 for families. Those 55 and older can contribute an additional $1,000 as a catch-up contribution.
- 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 from Roth IRAs are not taxed. One option traditional IRA owners have is converting a portion or all of their IRA holdings to a Roth IRA. The conversion amount is taxed as ordinary income in the year of conversion, but depending on your current tax bracket, this might be a good strategy. For example, if you retire early and no longer have W-2 income, you may have a window where you are in a much lower tax bracket than you will be in when you have to start taking required minimum distributions from an IRA and before you start taking Social Security benefits (at which point, your tax rates would go up because of the increased income). This could present a good opportunity to distribute a significant portion of your traditional IRA assets at a lower tax rate, and convert those assets to a Roth IRA, which will never be taxed again. You just have to be careful not to convert too much and bump yourself up into a higher tax bracket. You can no longer “unwind” or correct the amount you converted.
For the 2023 tax year, the IRS raised the standard deduction to $27,700 for married couples (an increase of $1,800) and $13,850 for single taxpayers (an increase of $900). Congress passed legislation in 2017 that doubled the standard deduction beginning in 2018. The 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 meant that fewer people itemize deductions on their tax return every year, since most people will not have deductions that exceed the increased standard deduction amount. 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 the total of these deductions is considerably higher than the standard deduction limit. For years that you do not have large deduction opportunities you would just use the standard deduction.
- Tax Loss Harvesting
While we certainly do not like stock market declines, we do look for opportunities to harvest capital losses that can be used to offset future capital gains taxes. For example, if you buy a mutual fund for $50,000 and it subsequently goes down in value $10,000, you could sell the fund and book the $10,000 capital loss. You could use the $40,000 proceeds to buy a similar replacement fund in the same asset class that you want to own in your portfolio. You can then 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.
Another thing to remember is that when you harvest a loss, the replacement fund you buy will now have a lower cost basis ($40,000 instead of $50,000), and will have an increased unrealized gain. Later when you sell the fund for spending needs, you will have a capital gain that is $10,000 more than if you had not sold the fund you originally bought for $50,000. Harvesting the loss can still be worthwhile though, especially if you are in a higher tax bracket when you use the loss vs. when you sell it later. Carry-forward losses are also very useful if you expect a big capital gain from the sale of a home or some other big asset in the near future.
- Asset Location
Investors who have a combination of taxable brokerage accounts and tax-deferred retirement accounts (IRAs, 401(k)s) should pay attention to where the different types of assets are located. If you own bonds or REITs (which typically generate more taxable income than stocks), those assets should be owned in tax-deferred accounts like IRAs or 401(k) accounts. You do not pay taxes on income generated in tax-deferred accounts until the assets are withdrawn. Assets that are expected to appreciate faster, like stock mutual funds, should be owned in taxable brokerage accounts. Although interest and dividends that are generated from stocks are taxed at your ordinary income tax 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.
- Qualified Charitable Distributions (QCD)
At age 70½ IRA owners can make qualified charitable distributions (QCDs) of up to $100,000 a year to a qualified charity, directly from their IRA. QCDs satisfy the Required Minimum Distribution (RMD, which now start at age 73 beginning in 2023), and the distribution is not included as taxable income. QCDs can be especially attractive for people who have an RMD, already make charitable donations, and want to reduce their taxable income. QCDs can also be appealing for those who use the standard deduction instead of itemizing deductions, because this ensures that they still get a tax benefit from their charitable donation that they would not otherwise get by using the standard deduction.
Though this is the time of year we are most focused on taxes, it is important to remember that effective 2023 tax planning can be practiced year round. With a careful review of your tax situation, and by considering some of the tax planning strategies mentioned above, hopefully you can minimize your tax burden and keep more of the money that you earn. As always, we are here to help with these issues, and any other financial questions you have. Please feel free to reach out to us.