The Power of Planning: Tax Planning
If you read my most recent blog, The Power of Planning, you may recall my attempt to convey the importance of creating and implementing a financial plan. You also may remember me stating that blog could easily have been ten pages long. There was a lot of truth to that claim.
Each topic that was briefly mentioned deserves more than a paragraph or two. With that in mind, I have decided to turn The Power of Planning into an ongoing series where I get into the specifics of how a financial plan can add value to our clients’ financial situations. To kick off the series, this blog explores the ever-so-fun topic of tax planning.
Overview of Tax Planning
Tax filing and tax planning are not one and the same. Filing your taxes with your state government and the federal government each spring will tell you if you have a tax bill or refund. This is not a service Aurora currently provides. Tax planning is a service we provide as part of the overall planning process, and it involves finding strategic ways to spend and save money to take advantage of deductions, tax credits, and as low of income brackets as possible.
Everyone’s situation is unique, so tax planning should be tailored to each client’s needs. We should aim to be proactive rather than reactive, hence why I’m putting this blog out now as people are filing last year’s taxes over the next month or so. If we can leave the first quarter of the year with a solid plan intact, we’ll have a better shot at reducing or even eliminating a tax bill come the following spring.
Tax Bracket Management
Lowering Your Current Taxable Income
When managing your tax bracket, the goal is often to lower your taxable income. The real question is whether to do so during your working years or in retirement. Whether this is during your working years or during retirement is the question though.
Most people are concerned with paying as little as possible in taxes right now. An easy way to lower your taxable income while saving for retirement is to save money to a pre-tax retirement account. Any money you save in the current tax year to a Traditional IRA, 401(k), 403(b), SEP IRA, SIMPLE IRA, etc. will be deducted from your income, leaving you with less of a tax bill than if you saved that money to a Roth account or a brokerage account.
If you run a business, make sure that your expenses are tracked and deducted from your business’s revenue. Losing out on potential tax deductions because you didn’t track expenses and therefore cannot prove how much your business spends is not desirable. There are way too many deductible business expenses to include in this blog, but here is a list of twenty common tax write-offs according to LegalZoom. If you are unsure whether or not an expense can be written off, please ask your accountant for clarification.
One deductible business expense I will emphasize, though, is depreciation. Depreciation is a method for accounting for the decreasing value of an asset over its useful life. In other words, as property, equipment, vehicles, etc. lose value as they get older, this loss in value can be deducted from your taxable income. For example, a company van that was once worth $50,000 will not be worth that same amount of money after ten years of wear and tear. Over time, the business would deduct the value lost each year for the van. Depreciation can be a major tax saver for businesses and rental property owners.
There are tax credits associated with higher education. Paying for qualified education costs can result in tax credits. Saving for education can result in a state tax credit if done through a 529 College Savings Plan (Indiana offers a tax credit for 529 plan contributions, but not all states do). As long as you track both education costs paid for and contributions made to 529 plans, your tax situation may improve.
These are some of the most common ways we see our clients lower their tax bills, and they’re all relatively simple to implement. However, there certainly are more strategies out there, and we can get as sophisticated as we need to. Which strategy we use is all dependent on the client’s unique circumstances.
Increasing Your Current Income to Lower Your Retirement Income
Although lowering your taxable income, and thus lowering your tax bill, seems like a rational maneuver, there are situations where it may make sense to recognize more income today, and I’ll touch on the most likely reason.
The most common reason to accelerate your income now is if you are trying to avoid higher tax brackets in retirement. If you are anticipating a higher income in retirement than you currently have, paying a little more in taxes today may be worth the tax savings you receive in the future. People who may have a higher taxable income in retirement could be those who saved a lot of money to pre-tax accounts, which can have large subsequent RMDs, those who will receive pensions on top of Social Security and other investment account distributions, those with deferred compensation plans or deferred annuities, or those who expect to receive a large inheritance.
While this is not the sole reason, the strategy of paying more in taxes today to save on taxes later is mainly centered around RMDs, or Required Minimum Distributions. When you have a pre-tax retirement account,the IRS requires you to begin taking distributions (for most people, this age will be 75) so as to not defer tax payments to Uncle Sam any longer than you already have. Remember, when you have money in a pre-tax retirement account, such as a Traditional IRA, you must pay taxes when you take distributions.
For some retirees, RMDs are a part of their planned retirement income. For others, these RMDs would push clients past their income goal, thus creating taxes for receiving funds they didn’t necessarily want or need yet. There are a few ways to lower your RMD amounts, which comes from lowering the amount of money in your pre-tax accounts:
Spend some extra money
Is there a project you’d like to get done soon? You could consider using some pre-tax dollars to fund the project.
Convert money to a Roth IRA
When you make a Roth conversion, you have to pay tax on the converted amount, as you are giving up the tax deferral of the pre-tax money. Once the money is in your Roth IRA, it will grow tax-free and will be distributed tax-free once the conversions have been in the account for at least five years. One key concept to note is Roth IRAs are not subject to RMDs.
Donating to a charity through QCDs
Qualified Charitable Distributions (QCDs) occur when you send money directly to a charity from your Traditional IRA. This will result in an above-the-line tax deduction that you can take advantage of if you are at least 70 ½ years old.
Taking Advantage of Lower Income Years
For those with variable incomes, in years in which you earn less than you typically would, you have a few tax strategy options at your disposal. For starters, you could stay put and accept the current situation. This could result in a tax refund or a smaller bill than normal. This certainly isn’t a bad place to be.
On the other hand, this could also be a time to take advantage of some strategies that would otherwise increase your income. For example, if you have a Traditional IRA that you want to convert to a Roth IRA, a down-year in income would be a great time to do that. The converted amount gets added to your income, making it fairly easy to project the impact of the conversion.
Unwinding capital gains in a lower income year can also be a wise decision. If you have a highly appreciated stock that you would like to start selling off, taking long-term capital gains in a down-year makes sense. The same can be said about rental properties as the increase in value to the property will be taxed as well. Long-term capital gains are taxed at a maximum rate of 20%, although most people see their gains taxed at 15%. Short-term capital gains are taxed at your marginal tax rate. Selling off gains is generally wise during these kinds of years, but selling short-term gains, which are incurred when selling an investment you’ve owned for less than one year, can be extra helpful.
Hidden Tax Traps
To no one’s surprise, there are certain things that can negatively impact your tax situation for the simple fact that these things are not common knowledge or easy to understand. How lovely of the IRS, right? Becoming aware of these tax traps can save lots of money in the long run.
IRMAA: Increasing your Medicare Premiums
To borrow from a previous section, let’s talk about yet another reason to want a lower taxable income in retirement. This reason revolves around Medicare planning. At age 65, you become eligible to enroll in Medicare. Assuming enrollment, Parts B and D have monthly premiums that you have to pay, and these premiums can increase based on your Income-Related Medicare Adjustment Amount (IRMAA). Simply put, as your income increases, your premiums for Medicare Parts B and D increase as well. Even going $1 over your current bracket can increase your premiums for the following year. That’s essentially what IRMAA does. So, it’s very important to manage your income when you are close to enrolling in Medicare. It’s also important to note that your income from two years prior is the income the Social Security Administration will use when calculating your Medicare premiums. Due to that fact, if you plan on enrolling in Medicare Part B or D once you turn 65, it would be wise to have a lower income at ages 63 and 64.
Social Security Tax Torpedo
Social Security retirement benefits are not taxable on their own, but they can become taxable if you receive an income while collecting benefits. If your sources of retirement income are Social Security and pre-tax retirement accounts, the money you withdraw from those retirement accounts could make your Social Security benefits taxable up to 85%. To be clear, this does not mean you lose 85% of your benefits to taxes. Rather, it means up to 85% of your benefits could be added to your taxable income. This same principle applies if you and/or your spouse are still working while the household is receiving Social Security benefits.
This phenomenon is often referred to as the Social Security “tax torpedo.” You end up paying more in taxes than you otherwise should for a given amount of income. If you were to take the same amount of income from a Roth IRA instead of a Traditional IRA, you would not encounter this tax torpedo as distributions from Roth IRAs are not taxable as long as you have had the account for at least five years and are 59 ½ or older.
With Roth dollars in mind, Roth conversions before turning on Social Security can be a way to avoid this tax torpedo. As I mentioned earlier, Roth conversion amounts do get added to your taxable income in the year the conversion is completed, but paying the tax now may be worth avoiding this tax torpedo when collecting Social Security benefits down the road.
High Dividend Earners in Taxable Accounts
Some investments pay out sizeable dividends to their shareholders, creating an additional stream of cash flow if the dividend is large enough. Many people reinvest dividends into their investments to add more to what they already have. For example, if you receive quarterly dividends from your favorite tech company, you could use those dividends to buy more shares of that company.
While free money is a great gift to receive, it’s important to understand that dividends aren’t truly free. Most dividends are taxed at your marginal tax rate, simply adding to your overall income number when you hold those dividend payers in a taxable account. In a brokerage account, whenever you earn bank interest, receive dividends, or take capital gains by selling a security, you are adding to your income.
If you want to be invested in certain companies or funds that pay whopping dividend amounts, you are best to do so in a pre-tax or Roth account rather than a taxable one. In brokerage accounts, we often use municipal bond funds as interest received from those funds specifically are tax-free in most cases.
The Bottom Line
This blog touches on many topics while only scratching the surface of each. To ensure that I don’t make this blog an hour’s worth of reading, I’ll wrap things up here. I decided to cover the most common tax strategies that we have come across over the last few years here at Aurora. There are certainly other strategies worth considering, so there may be a part two to this blog one day. Who knows, though?
At the end of the day, the best course of action when it comes to taxes is to look at the bigger picture and make sure everything fits well together in the grand scheme of things. Some of the topics discussed in this blog may make sense for your situation, while others will not. There may be something I didn’t get to go over that would be an even better idea for you.
Finding the best solutions for your tax situation is our goal, and that best occurs when we are able to sit down with you and plan for your specific needs. If you are interested in doing an analysis of your tax situation or getting into financial planning in general, please reach out to a member of our team. We’d be happy to care for your tax planning needs.