Reducing your tax bill is an important financial planning goal. Here are five evergreen strategies for shrinking the amount of taxes you owe.
1. Max out contributions to your retirement accounts
Contributions to workplace retirement savings plans and IRAs reduce your current taxable income. In 2019, you can contribute up to $19,000 to 401(k), 403(b) and most 457 plans. People aged 50 or over can generally contribute another $6,000 per year.
If you are self-employed, you may be able to contribute up to $56,000 (or $62,000 if over age 50) to a self-employed 401(k).
In addition to a 401(k), you and your spouse can also contribute to IRAs. IRA contributions are capped at $6,000 per year, plus an additional $1,000 for people over 50. Your IRA-related deduction may be limited if you or your spouse are covered by a retirement plan at work and your income exceeds certain levels.
Retirement fund contributions can help limit your exposure to the 0.9% Medicare Hospital Insurance (HI) Tax, which went into effect in 2013 as part of the Affordable Care Act. This tax is levied on married couples with wages or self-employment income of $250,000 or more, and individuals with income of $200,000 or more.
2. Charitable Gifting
Gifts to non-profits create tax advantages. Some specific strategies can help maximize your tax savings.
■ Donate long-term appreciated securities rather than selling them and then donating the proceeds. This will allow you to donate and deduct the full value of the investment without paying capital gains tax. On the other hand, shares that have lost value should be sold before donating them, to allow you to record a capital loss, which reduces your taxable income.
■ Set up a Donor Advised Fund (DAF) – Also known as a Charitable Gift Fund, a DAF is a simple and inexpensive option for gifting highly appreciated securities. Contributions to a DAF create an immediate tax deduction. Donors can then grant funds to charities immediately or over several years.
■ Bundle your deductions – With the increase in the standard deduction to $24K (for married taxpayers) and $12K (for single taxpayers), bundling your deductions may help reduce your tax bill. For example, making a large donation in one year instead of annual small donations may enable you to receive a greater tax benefit.
■ Donate your IRA RMD directly to charity – After reaching age 70-1/2, IRA owners must take an annual Required Minimum Distribution (RMD) from their account. By donating that RMD amount directly to charity, you can exclude that money from your taxable income.
3. Roth IRA Conversions
If your income temporarily falls in a given year, moving you into a lower tax bracket, it may make sense to shift some of your traditional IRA funds into a Roth IRA. You may incur taxes on the distribution, but at a lower rate, and the remaining funds will grow tax-free. Likewise, an IRA that has lost value as a result of market fluctuations might also be a good candidate for a Roth conversion. If your IRA has a “basis” – meaning you’ve made after-tax contributions in the past – you may be able to convert to a Roth at little or no tax cost.
Roth IRA contributions are not permitted for individuals with adjusted gross income above $137,000 and couples above $203,000 for 2019. But Roth conversions have no income restriction.
4. Reduce Capital Gains Exposure
Harvesting losses in the same year as your gains will reduce your taxable income. If you plan to sell investments which have appreciated significantly, consider selling others that have lost value. If your losses exceed your gains, you can deduct them on your tax return, up to $3,000 per year. Additional loss amounts can be carried forward to offset gains in the future.
Three additional strategies can be utilized to help minimize your tax burden:
■ Hold securities for at least one year. Sales before the one-year mark are deemed short-term and any gains will be treated as ordinary income. Marginal tax rates are typically much higher than the long-term capital gains rate.
■ If you are a high income earner, you may be subject to the 3.8% Net Investment Income (NII) Tax. This tax can be avoided if you keep your income below the NII threshold ($250,000 for married couples and $200,000 for individuals).
■ If your income falls into the lower tax bracket, consider harvesting capital gains to take advantage of the 0% capital gains rate. Or consider gifting appreciated shares to adult children or parents who may be in a lower tax bracket, so they can sell the appreciated shares and take advantage of the 0% capital gains rate.
5. Adjust Your Portfolio Structure
Different asset classes can be strategically placed in different types of accounts to generate the most favorable after-tax result. Through this practice, known as Asset Location, higher growth-oriented assets are placed in tax-deferred or tax-free accounts, while tax-exempt income sources like municipal bonds are placed in taxable accounts.
Proactive tax planning is an important component of financial planning. Your Paracle advisor would be happy to discuss the strategies covered here and explore the best options for helping you lower your tax bill with your CPA.
We’d like to thank Don Archiable, who contributed to this article. Don is a Seattle area CPA who focuses on personal and small business clients’ income tax planning and compliance. He can be reached at firstname.lastname@example.org for additional information.