This blog has been updated and slightly modified from a version originally published on Zoe Financial.
Procrastination is a woe many of us strive to understand and manage. Seasonality may have quite a bit to do with why we put things off. In fact, 76% of shoppers say they put off making holiday purchases right up until Christmas. While you can put gift shopping off until you start hearing holiday jingles, and reap the benefits of a few extra sales, it could be well-worth your time and money to jump on spring, and “tax season,” early!
Most individuals only think about taxes during filing season – which largely runs from January to April. Yet, this approach has a significant downside. It’s reactive rather than proactive. It doesn’t allow you to plan. If you want to lower your tax bill, think about taxes throughout the year. It can save you money. Good tax planning can leave you with more money both today and tomorrow.
Why? When you gather information to prepare your return, the year is already over. While you can increase your retirement account contributions before filing your return, you can’t do much else to lower your tax bill.
For investors, taxes take on even greater importance. Taxes and investing are essentially joined at the hip. Paying lower taxes on your investments should add to your portfolio’s value.
If you want to lower your tax bill, consider some of the following suggestions.
Pay Lower Taxes with Charitable Planning
Are you charitably inclined? Do you hold appreciated stock in a taxable account. Consider donating it rather than cash. It allows you to avoid capital gains taxes and claim a deduction for the stock’s fair market value. For example, if you want to donate $25,000 to your favorite charity, give them appreciated stock, not cash. If you paid $10,000 for a security that is now worth $25,000, you’ll get a $25,000 tax deduction and won’t pay any taxes on the gains. If you sold the stock and then donated the cash, you would pay capital gains taxes on the $15,000 gain ($25,000 less $10,000).
Once you reach age 72 you must take required minimum distributions (RMDs) from retirement accounts such as IRAs. Assume you want to donate $10,000 to the charity of your choice. If you receive your RMD and then donate the $10,000, the contribution is considered an itemized deduction. In 2020, the standard deduction for a couple filing a joint return is $24,800. Depending on your tax facts, you might not get any tax benefit from this donation. Consider a qualified charitable contribution (QCD) by making the donation directly from your IRA to the charity. If you make a QCD, the RMD is excluded from your income. That’s a better outcome. Note: While you don’t have to start taking RMDs until age 72, you can start making QCDs at age 70 ½.
Tax-loss Harvesting to Lower Your Bill
Unfortunately, some investments decline in value. Consider selling securities when you have a loss. These losses can offset taxes owed on any gains realized from other securities you sold during the year. Losses offset gains of the same type (short- or long-term). You can also realize up to $3,000 of excess losses each year and carry the balance over. One caveat. Be aware of the wash-sale rule. Taxpayers can’t claim a loss if they buy the same or a similar asset within 30 days of selling the same or similar security.
ETFs Rather Than Mutual Funds
Do you hold investments in taxable accounts? If so, consider ETFs instead for their tax efficiency.
Gains mutual funds realize from selling securities are distributed to the fund holders. Plus, mutual funds must sell underlying securities to free up cash for redemptions. The net gains a mutual fund realizes during the year are typically distributed to fund holders in December.
On the other hand, the buying and selling of exchange-traded funds occur through an exchange, making them more tax-efficient. As a result, the ETF sponsor is not required to redeem shares whenever an investor wishes to sell, or issue new shares each time an investor wants to buy. If you own an ETF, your dividend income will still be taxed, but you won’t receive unexpected capital gains distributions.
Consider Types of Tax-deferred Accounts
There are many different types of investment accounts. For example:
- Health Savings Accounts (HSAs)
- Roth IRAs
- IRA/401(k)/403(b)
- Taxable investment accounts
If you have a high-deductible health care plan, HSAs are a must. They are triple-tax free. Money goes into the account tax-free. Your investment grows tax-free. Money used for qualified healthcare expenses can be withdrawn tax-free, too. Contrast this to a Roth IRA (you deposit after-tax money) or an IRA (you pay tax when you withdraw money).
Depending on your facts and circumstances, it can also be helpful to convert an IRA to a Roth IRA. (Note: You don’t have to convert the whole account. Partial conversions are allowed.) Sometimes paying taxes now can be more beneficial than paying them later. Once you reach retirement, especially if you save diligently, your tax bill may be higher than you expect.
You want to be strategic about how you add money to or withdraw money from your tax-favored accounts. Planning to take money out of your tax-deferred accounts while you are in a lower tax bracket – even if you don’t plan to spend it – can be beneficial.
Delaying the start of your Social Security income can have benefits beyond increasing how much you receive. It can also help you create a low-income year or years. Use that period to lower your overall tax rate. Taking money out of your retirement accounts in low-tax years can reduce the total taxes paid during your lifetime.
Consider Asset Location
Real estate investors often emphasize the concept of “location, location, location.” Although many overlook it, location matters to investors, too.
In short, asset location refers to what type of account holds each investment. Investments can be held in tax-deferred accounts (e.g., IRAs), taxable accounts, or tax-exempt accounts (e.g., Roth IRAs). Paying attention to asset location can improve your investment returns by reducing your tax bill.
If an investor has more than one type of investment account, she should consider which type of asset goes into which type of account. For example, interest income is taxed currently. High-yield bonds and bond funds may be better suited for your IRA, especially if you don’t need the money now. On the other hand, stocks can generate long-term capital gains. If you do not trade frequently, such assets may be better suited for your taxable account.
Open a Roth IRA for Your Child
If your child has earned income from a summer job or working during the school year, consider having them open a Roth IRA. If you have the funds, you can even make the contribution for them so that they can keep what they earn.
A Roth IRA is a particularly good choice for a young saver because it can provide decades of tax-free growth. If your child is under 18 or 21 (it varies by state), the account must be opened by an adult as a custodial account. Once your child is of legal age, they will have full access to the money.
The big advantage of this strategy is that it allows your child to take full advantage of the benefit of compounding. If you save $1,000 in a Roth IRA now, and it earns 6% annually, in 50 years it will grow to more than $18,000.
One caution: While owning a Roth IRA will not affect a student’s financial aid eligibility, IRA withdrawals and gifts can count as income for aid calculations. Some colleges may also hold the existence of an IRA against you in their aid formula by counting them as student assets that are assumed to be drawn down at a 25% rate.
Concluding Thoughts
We hope the above gives you some idea of the benefits you’ll receive if you pay attention to taxes throughout the year. Don’t treat taxes as a necessary evil you have to deal with at the start of each year. Proactive tax planning can help lower your tax bill and increase your portfolio’s value.
Still have questions? Schedule a free 15-minute call.
Phil Weiss founded Apprise Wealth Management. He started his financial services career in 1987 working as a tax professional for Deloitte & Touche. For the past 25+ years, he has worked extensively in the areas of financial planning and investment management. Phil is both a CFA charterholder and a CPA.
Located just north of Baltimore, Apprise works with clients face-to-face locally and can also work virtually regardless of location.
