Keep in mind the tax code changes frequently. Understanding what tax planning strategies are available, as well as how and when to use them is critical.
1. Pre-Tax Savings & Tax Deferral
Deferring taxes is a great wealth building strategy. 401ks and 403bs have given us the ability to save money before it’s taken from us (taxed). For someone in the 30% tax bracket, this is the difference between having $1 invested vs $0.70. An additional benefit comes when the full dollar appreciates. A 10% return on $1 = $1.10, as opposed to a 10% return on $0.70, which would be $0.77 with after tax dollars. Although retirement assets are taxed upon withdrawal, the probability of withdrawing at lower tax rates in retirement is a high probability for most people. Maximizing your 401k should reduce taxes paid.
2. Tax Deductions
The government provides various tax deductions to reduce our tax liability. It’s important to maximize these deductions over our lifetime. Key tax deductions include mortgage interest, property taxes, charitable contributions, medical expenses, professional service fees, and more. Identifying these available deductions within the context of your financial plan and implementing over your lifetime can generate a large savings.
3. Charitable Contributions
Charitable contributions are one of the key tax deductions listed in #2. There are multiple ways to maximize charitable contributions in an effort to reduce taxes. Charitable strategies can be used to reduce taxes in the current year, in future years, and at death. It’s important to maximize your charitable giving throughout your life, and at your death. Gifting appreciated securities to charities, rather than cash, is a tax efficient strategy. For those over the age of 70 ½ with retirement accounts, gifting directly from your IRA accounts is more tax efficient than giving cash.
4. Tax Credits
Tax credits are the holy grail of tax savings. A tax credit is a dollar-for-dollar reduction in the amount of taxes you will pay in a given year. Available credits includes the Child Tax Credit, American Opportunity Tax Credit, Lifetime Learning Credit and more. These credits phase out as your income increases beyond certain levels. However, it is possible to use strategies to reduce income to help you qualify for these valuable credits.
5. Structured Retirement Income
Coordinating when to start Social Security, pensions, and distributions from retirement accounts can significantly lower your lifetime tax liability. Deciding when to start Social Security should be looked at not only as a strategy to maximize lifetime income, but more importantly, to maximize your overall financial plan, which requires a review of the tax impact of each claiming strategy. Retirement accounts have a required minimum distribution (RMD) that must begin at age 70 ½, so anticipating this event and incorporating various strategies can lower tax liability. In some circumstances it makes sense to begin drawing income from retirement accounts before the required date.
6. Avoiding Tax Cliffs
Federal income tax brackets are typically progressive in nature, meaning only the next dollar of earnings is taxed at a higher rate. However, Medicare premiums operate more as a tax cliff. Your premium is based on income, with various brackets set up to determine your payment. If your income is only $1 more than the minimum level in a given bracket, you pay 100% of the premium for that bracket. Tracking and managing your income level, as discussed in #5, can have a large impact on your tax liability.
7. Bracket Maximization
The IRS assigns higher tax rates to various income levels, which we call tax brackets. In any given year, you may find yourself in the lower or middle level of a given tax bracket. One strategy to minimize lifetime taxes is to realize more income in a given year in order to utilize the entire amount of your current tax bracket. This strategy works well when you anticipate being in a higher bracket in the future. In summary, you are pulling income into your current tax year while you are in a lower bracket, in order to minimize income in future years when you may be in a higher bracket. A typical strategy to facilitate this additional income is a partial roth IRA conversion.
8. Capital Gains vs Income Tax
There is a much lower tax rate for assets producing long-term capital gains relative to income or short-term gains. Maximizing assets that generate long term appreciation and minimizing assets that produce short-term gains or interest income will significantly lower lifetime taxes.
9. Education Savings
Saving money for a child or grandchild’s education can be done tax efficiently. 529 College Savings Accounts allow for tax free growth of assets if the funds are used for higher education expenses. In addition, you may qualify for state income tax deductions on contributions to your state sponsored plan. It’s a double benefit of tax savings if done correctly.
10. Coordination = Minimizing Lifetime Taxes
Employing all of the above strategies in a unified manner can add significant wealth over time. Initially, it may seem as though each strategy produces only marginal gain and that tax planning is a zero sum gain, but there are specific strategies that can lower your lifetime taxes and provide more assets for you and your family.