Tax planning is the art of looking into the future and trying to make decisions that lower your lifetime tax bill. This is something that does not come naturally to most, and can become very complicated. Most people have a CPA or use turbo tax to file their taxes. When you file your taxes, you are looking backward on the year that already happened. There is nothing that you can do to influence your future taxes, as you are looking at a historical record. What we want to do with tax planning is look through the windshield at future taxes, not through the rearview mirror at things we cannot control.
Top 5 Considerations
1. Estimated Taxes and Withholdings
Everyone that has a W-2 job has tax withholdings. The basis of any tax analysis should aim to land your tax bill within $1,000 of a refund or a payment at tax time. We don't want to owe the IRS a bunch of money, but we also don't want to way overpay them throughout the year and get no return on that money. This necessitates being able to estimate your tax bill, and calculating how much you will have in withholdings. Turbo tax has a nice tool here to do this: https://turbotax.intuit.com/tax-tools/calculators/taxcaster/
If you are going to be short on taxes, you can increase withholdings, as well as make an estimated tax payment. Estimated payments are usually required for those that are self-employed, have irregular income, RSUs, or bonuses toward the end of the year.
2. Capital Gains/Loss Harvesting
These strategies are only for those who have investments in a taxable brokerage account, so not an IRA or 401(k)/TSP. This is the practice of intentionally selling a position that you own in a taxable investment account. This can be done either to harvest a loss, or harvest a gain.Tax loss harvesting is typically most beneficial for those that are in relatively high income brackets compared to their lifetime bracket. By selling a position at a loss and replacing it with a different security, one can harvest that loss, maintain the integrity of the portfolio, and use the loss to offset other capital gains, or offset up to $3,000 of ordinary income. This is a complicated endeavor, as there are all kinds of rules with not being able to buy back the original security within 30 days to comply with the (IRS Wash Sale rule) as well as needing to avoid purchasing a “substantially identical security” as loosely defined by the IRS. The benefits of this practice can range from 0.2-0.4%. This is a little complicated and should be taken cautiously.
Much simpler is the practice of tax gain harvesting. This is an awesome opportunity for those in the 0% capital gains tax bracket. In 2022 that is anyone with less than $41,674 for single or $83,350 married filing jointly. People could be in a low tax bracket for all kinds of reasons from being in the military, being in college, taking a sabbatical, or recently retiring. This is simple because it just involves selling a security for a gain, and just buying it right back the same day. You get to lock in your gain and step up your basis for $0 in tax if you can keep it under the above thresholds when added on top of your taxable income. This is an awesome opportunity to pay $0 in tax and maintain the composition of your investment portfolio.
3. Roth Conversions
This is for those that have money in a Traditional IRA. This involves converting a portion of this pretax money to a Roth IRA, and adding that to your taxable income for the year. This usually makes sense for those that are in a lower tax bracket for the year than they anticipate in the future. It can also make sense if you are $10,000 or $20,000 from the next tax bracket. this allows you to fill up your current bracket but not go over and be subject to the next higher bracket. It is good to have some tax diversity in your retirement income, so that you have the option to take money out tax free from a Roth IRA and do not always have to pull from pre-tax assets. Lastly, it can also make sense to consider a Roth conversion when the market is declined, as the you can convert more shares of stocks/bonds per dollar of tax if the value of your accounts are down. Voya has a solid calculator to illustrate and visualize Roth conversions.
4. HSA and IRA contributions
This is for those that want to put money away for retirement, but want to drive down their taxable income for the year. Traditional IRA contributions will drive down your taxable income for the current year. The income limits for being able to deduct these contributions are $78,000 for single and $129,000 for married filing jointly.
Conversely, Health Savings Accounts (HSAs) have no income limits. You can contribute $3,650 for single, $7,300 for families, and $1,000 catchup contribution for those over 50. These funds lower your taxable income, grow tax free, and are tax free when taken out for qualified health expenses. You can even reimburse yourself decades from now for expenses you incur today, with totally tax free, compounded growth. The HSA is commonly referred to as the “holy grail” of retirement savings due to this triple tax savings. Unfortunately the HSA is not for everyone as you have to have a high deductible health plan ($1,400 for individual, $2,800 for family) and TRICARE enrollees are ineligible.
5. Charitable Donations: DAF and QCDs
For those that are charitably inclined, Qualified Charitable Distributions (QCDs) and Donor Advised Funds (DAFs) can be extremely beneficial form a tax standpoint. The tax code makes deducting charitable contributions in the current year useless for the majority of taxpayers. This is because of the high standard deduction of $12,950 for single or $25,900 for married filing jointly. In order make enough of a charitable contribution to get over those thresholds, one can open a DAF to make a large contribution in one year. The donor gets the tax break in that year, and then the fund can invest the money and distribute the funds to charity over a number of years. This is an outstanding way for someone who is charitably inclined and needs to bring down taxable income for an inordinately high earning year. Here is a good place to start looking at DAFs.
The other strategy is for those who are withdrawing from their Traditional IRAs and are charitably inclined. IRAs are pre-tax so the IRS requires a certain amount to be distributed every year. Instead of taking that distribution and paying tax, someone can take all or a portion of the distribution and donate it to charity where it won’t be taxed. For someone who is not currently giving to charity, this doesn’t make sense as they will be worse off now as they need to replace that income. But for the charitably inclined, this is a home run as they get to satisfy their RMD and their charitable desires with pretax money, essentially bypassing the IRS. Check with your IRA provider on the best way to execute QCDs as every provider is a little different.
The U.S. tax code is mind numbingly complex. Furthermore, our society focuses on filing taxes properly and working with Turbo Tax and CPAs which is inherently backward looking. Not many people out there are doing true, forward looking tax planning. By doing some timely planning and forward looking exercises toward the end of the calendar year, we can hopefully make decisions to lower our lifetime tax bill.
**Disclaimer: please speak with a financial planner and/or CPA before implementing any of the above tax planning for your personal situation. **