Tax Day is over, and it seems that many taxpayers are still catching their breath from the big check owed to the IRS. Though paying taxes isn’t fun, it does suggest that you’ve realized a decent amount of income during the year. To minimize taxes in future years, consider being more strategic in your tax planning by making some simple financial adjustments.
Increase Pre-tax Retirement Contributions
If you’re employed, contributions made to your employer’s retirement plan (401k, 403b, 457b) are deductible from income; thus, no tax is assessed on your contribution amount. The same is true for self-employed retirement accounts (SEP IRA, Simple IRA, Solo 401k). If you’re not already contributing to a retirement account or not contributing the maximum amount, consider deferring at least 5 to 10 percent of your income to the account or increasing your current contribution amount to the maximum.
These contributions don’t only help build a nice retirement nest egg; they also help reduce your taxable income during your high-income working years. (Retirement account contribution limits for the year 2022 can be found at: https://www.irs.gov/newsroom/irs-announces-changes-to-retirement-plans-for-2022)
Eligible for a Health Savings Account?
Maximize your contribution to the HSA if possible. Any amount of contribution will help now and in the future. Not only are your deposits to the HSA deductible from income, but distributions also are not taxable when used for qualifying health care expenses. That’s a win-win! (Information about health savings accounts and the contributions limits can be found at: https://www.healthcare.gov/glossary/health-savings-account-hsa/)
Qualified Charitable Distribution (QCD) from IRAs
If you’re age 70 ½+, consider making your gifts to charity directly from your IRA via the QCD rather than by cash or appreciated securities, especially if you use the standard deduction. Direct donations to a 501(c)(3) organization from the IRA are not subject to income taxes. However, they are also not eligible for a deduction on Schedule A. The maximum of $100,000 can be donated to charities via the QCD per year. If married, both spouses can max their donations from their respective IRAs at $100,000. The QCD also satisfies the required minimum distribution amount from traditional and Inherited IRAs.
Note that your tax form 1099R will not distinguish the amount of your IRA distribution allocated to charities. So make sure you keep a record of those that were and remember to indicate your charitable gift amount on your tax return!
Lump Charitable Gifting
Will you incur a larger tax event in a given year? Maybe a large bonus, the sale of a business, or even a sizable Roth conversion? If you’re charitable, you could benefit from utilizing a donor-advised fund (DAF) to make a larger donation in this high-income year. For example, if the typical amount you gift to charities is $15,000 per year, consider making 3-years’ worth of those gifts to the DAF in the high-income year ($45,000 donation). The gift is deductible on Schedule A, exceeding the standard deduction amount. Then, use the DAF to fund your charitable gifts in future years. (Gifts from with funds from the DAF are not tax-deductible.)
Capital Gains on an Investment
Maybe you sold an investment that incurred a large capital gain. Capital gain taxes are assessed on the difference between your purchase price and the sale price. For example, if you purchased 100 shares of Amazon stock in 2019 for $1,900 per share and sold those 100 shares at $3,500 per in 2021, you would incur $160,000 of long-term capital gain. Depending on your income situation, you would be required to pay 15% to 23.8% on those gains, and in the majority of states, an additional state income tax, up to 13.1% depending on the state. Even 15% of $160,000 is a $24,000 tax hit on that nice gain! If the shares were held for less than 12 months before the sale, that $160,000 short-term gain would be taxed at your ordinary federal and state income tax rate. For some, the federal tax rate alone is 37%!
Know that short and long-term capital losses can offset long-term capital gains. Short-term losses are first used to offset short-term gains. Any excess is applied against the long-term gain. If you have an investment(s) that has taken a dive, you might want to sell and realize the loss for the offset. Want to buy that investment back? Wait at least 30 days to avoid the wash-sale rule, causing you to forgo the loss offset.
Having high taxable income sounds and feels great until tax time. Make a point to talk with your tax preparer or financial advisor to do an estimated tax projection mid-year, then develop a plan for minimizing taxes that makes sense for you. Implementing the plan won’t only reduce your tax bill, but it may benefit you financially over the long term!
Kathy Hower, CFP, is a Senior Wealth Advisor with Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. For more information, visit their website at www.bedelfinancial.com or email Kathy at firstname.lastname@example.org.