Preparing a strategy that is both advantageous and tax-efficient might feel daunting at times. Thankfully, there are some things you can do now to keep from overpaying income tax.
Build Your Team of Professionals
Building a financial team to manage your taxes usually means talking to more than one person. Your trusted financial planner can speak to many financial issues, but your situation may call for them to consult with others who have specialized training.
As with the search for any professional, the best place to start is with a referral from someone you trust. Your financial planner may have worked with a CPA or an Enrolled Agent (EA) who can help you. Or friends or family may know someone who fits your needs.
Tax-Focused Investment Strategies
Once you have the right team of financial professionals who understand your financial situation, they can advise you on the right path for you. You may want to ask them about some of these investment strategies:
Backdoor Roth IRA
If you are a high earner with an income above the IRS’s income limit for Roth IRA accounts, you still have the option to create a backdoor Roth IRA. (At the time of publication, Congress is considering legislation that would eliminate this opportunity.) Just as it sounds, this option allows high earners to bypass the income limits and still utilize the tax advantages of a Roth IRA account.
To create a backdoor Roth IRA, you’ll need to:
- Open and contribute to a traditional IRA.
- Convert your traditional IRA to a Roth IRA account (consult with your advisor or account custodian to do this).
- Pay the income taxes on any contributions that were deductible (paying back the tax deduction you received when you initially contributed to your traditional IRA).
- Pay income tax on any additional gains your traditional IRA account may have made over time.
Unlike your traditional IRA, the value of your Roth IRA grows not just tax-deferred, but tax-free. And Roth IRAs do not have annual Required Minimum Distributions (RMDs) the way traditional IRAs do.
When considering a backdoor IRA, your advisors can help you evaluate the tax obligations you would pay this year versus the tax benefits you (or your survivors) may realize later in life.
Several tax strategies can help you manage your taxable income and taxable estate. While this discussion is informational only, your financial, tax, and legal advisors can help you decide whether to modify your gifting strategy.
One tax-advantaged approach is giving a charity appreciated securities you have held for at least a year. In addition to a potential tax deduction for the fair market value of the securities, the charity can then sell the securities and pay no capital gains tax (since a charity’s tax rate is zero).
For those who’ve reached age 70½, a Qualified Charitable Distribution (QCD) from a traditional IRA can be an even better choice. Your IRA custodian can issue a check payable directly to a charity. You don’t pay tax on a QCD, and if you’re subject to annual Required Minimum Distributions, the QCD counts toward that requirement.
For those who might be subject to estate taxes, the annual gift tax exclusion gives you a way to remove assets from your taxable estate. You may give up to $15,000 per year to as many individuals as you wish without paying federal gift tax. This is in addition to lifetime gifts that total less than the lifetime estate and gift tax exemption (more than $11.7 million for 2021).1 The annual gift tax exclusion can involve a complex set of tax rules, so we recommend working with a professional familiar with this strategy.
Tax-loss harvesting refers to the practice of taking capital losses (you sell securities worth less than what you first paid for them) to help offset the capital gains you may have recognized. While this doesn’t get rid of your losses, it can help to reduce your tax liability.
Up to $3,000 of capital losses in excess of capital gains can be deducted annually ($1,500 per spouse if Married Filing Separately). Any remaining capital losses can be carried forward to offset future capital gains.2 But remember, tax rules are constantly changing, and there is no guarantee that the treatment of capital gains and losses will remain the same in the coming years.
By taking losses this year and carrying over the excess losses into the next, you can potentially offset some (or maybe all) of your capital gains next year. Of course, before moving ahead with a trade, it’s important to understand the role each investment plays in your portfolio.
If you’re looking into this strategy, be aware of the tax code’s wash-sale rule: investors can’t claim a loss on a security if you buy the same security (or one that’s substantially identical) within 30 days before or after the sale.3
These strategies are just a few examples of actions you may be able to take now to address both your current tax obligation and those you may have to deal with further down the road. Remember, while tax-filing season usually ends on April 15, we believe tax season runs all year long. Many strategies require you to act before the tax year ends, and these can be the most important (and effective) strategies for lawfully reducing income tax liability.
Want to learn more about tax planning that really works? Give us a call.
This content is developed from sources believed to be providing accurate information and is provided at least in part by Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security. Original content of Practical Financial Planning, Inc. only is copyright © 2021 by Practical Financial Planning, Inc.