Five Tax Planning Strategies to Use All Year to Lower Taxes
Proactive ways to lighten the tax load include deferring or accelerating income, tax-loss harvesting and bunching several expenses into one year.
To minimize your tax burden and make the most of your money, you need to switch from a reactive to a proactive mindset when it comes to taxes.
Here are five strategies you can use year-round to be more proactive about your tax planning.
1. Deferring Income
When you have high-income, high-tax working years, you might want to defer that into your low-tax, nonworking years, like retirement.
See if your company offers a nonqualified deferred compensation plan where you can defer some of your compensation into the future. You can access those funds after a trigger event, like when you leave the company, retire, become disabled or reach a certain age. This income is only taxable when you receive it.
These plans reduce your short-term taxable income and grow your wealth, but only if you’ll be in a lower tax bracket in retirement. You need to balance cash flow and tax rates today and pay attention to what your future tax rates might be.
2. Accelerating Income
In low-tax years — like when you’ve switched jobs, lost a job and are out of work for a few months, or work on commission and had a slow year — accelerate your income.
There are a few simple ways to do that: If you’re employed and paid hourly, work more hours if you can. You could also get a second job.
But there are more complex ways to do this: sell a business, sell real estate or investments or do a Roth conversion.
When you sell a business, you may defer the proceeds to the future by receiving the sales price over annual installments, which limits the tax impact. However, you may choose a lump-sum payment for your business to recognize the income in a low-tax year.
With a Roth conversion, you convert tax-deferred money from your traditional IRA or 401(k) accounts to a Roth IRA, which might allow for tax-free distributions in the future. When you do a Roth conversion, you must pay taxes on any portion of the traditional IRA for which you had taken a deduction.
Doing a conversion in a low-tax year — as opposed to pulling money out in a high-tax year — can be a valuable tax planning strategy.
3. Taking Required Minimum Distributions
When you turn 73, you must take taxable required minimum distributions (RMDs) from your qualified retirement accounts (Roth IRAs and Designated Roth accounts excluded). To figure out how much you have to withdraw, check the IRS Uniform Lifetime Table for the number that corresponds to your age and then divide your account balance as of Dec. 31 of last year by that number.
Retirement can be a time when things like taxes on withdrawals from retirement accounts and investment earnings can add up. Without planning strategies, the additional income could add up to tens of thousands of dollars in extra taxation over time.
You must also consider how higher taxable incomes due to rising RMDs over the years will impact taxes on Social Security payments and create higher costs for Medicare premiums.
While each person’s tax-saving strategy will differ, some common tax-saving strategies in this area include taking an RMD as a series of installments during the year or converting your traditional IRA to a Roth IRA.
4. Tax-Loss Harvesting
Offsetting capital gains by intentionally selling shares of assets that will generate losses is called tax-loss harvesting. Investors commonly do this in December by assessing their portfolio performance to offset the effects of any losses with gains.
Investors must be aware of the 30-day wash sale rule, which prohibits you from “locking in” a loss by buying substantially identical securities within 30 days before or after selling an investment at a loss.
While common in December, you must understand when and why you should do tax-loss harvesting, which is where your financial professional is especially helpful.
Bunching is a smart tax strategy for people who want to maximize their itemized deductions. By bunching several expenses into one year, you increase the chance of going above the standard deduction amount and being able to itemize your deductions in one single year, resulting in more significant tax savings. For example, if you normally give your favorite nonprofit $1,000 a year, you can give $10,000 in one year instead.
But bunching isn’t just for charitable contributions — it can also include business expenses, medical expenses and 529 plan contributions to create a larger income tax deduction in a given year. Keep in mind that certain expenses have a cap, or limitation, on how much can be deducted per year, so make sure you understand those caps and limits so you can take full advantage of the bunching strategy.
Talk to Your Professional
Being proactive about your taxes in the optimal way for your individual situation requires the help of a financial professional. A professional can help you determine whether any — or all — of these strategies is right for you.
While death and taxes are both certain, death happens only once, while taxes come every year. So proper tax planning with a qualified professional is vital.
This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.
Jamie Hopkins is a well-recognized writer, speaker and thought leader in the area of retirement income planning. He serves as Director of Retirement Research at Carson Group and is a finance professor of practice at Creighton University's Heider College of Business. His most recent book, "Rewirement: Rewiring The Way You Think About Retirement," details the behavioral finance issues that hold people back from a more financially secure retirement.
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