END OF YEAR TAX STRATEGIES

Welcome to The Wealth Span - if you want to join the growing list of folks learning about investing for longevity each week, subscribe below...

Feel free to read the most popular posts and connect with me on LinkedIn!

Now - today's post...

___________________________________

Nobody likes to pay taxes. Unfortunately, taxes coming due is one of the few inevitabilities each year. The IRS always has their hand out, ready to accept any funds owed to them.

Throughout life, taxes will probably be your largest cumulative expense. It is estimated that the average American will pay about 34% of their lifetime earnings in taxes.

I would say it is safe to assume the readers of The Wealth Span aren’t the average - we should probably expect to have higher earnings over our lifetimes. As is always the case, higher earnings will result in higher taxes. Because of this, you might easily pay millions of dollars in taxes over the course of your life.

Fortunately, these millions won’t come all at once but rather will be a slow drip via your annual income tax filing for individual investors or quarterly estimated payments for business owners.

The end of the calendar year is a logical place to finalize different components of your financial life and tax planning strategy. Although many tax related items share the April 15th deadline, a nearly equal set have a deadline of December 31st.

Since taxes consume such a large portion of your earnings and have an outsized mind-share in planning for retirement, it becomes increasingly important to execute effective strategies to lower your taxes over the course of your lifetime.

___________________________________

Roth Conversions

Simply put, a Roth conversion transfers dollars from a Traditional IRA to a Roth IRA.

For a quick overview of these two variations of the IRA:

1/ With a Traditional IRA, you will pay taxes on any withdrawals in retirement. With a Roth IRA, you can enjoy the compound growth of dollars without the impending doom of taxes.

2/ A Traditional IRA will have required minimum distributions (RMDs), but there are no forced withdrawals or RMDs for a Roth IRA.

Your tax preparer and financial advisor/wealth manager should coordinate their efforts to complete this process. They will complete a few calculations to determine whether a Roth conversion would be right for you. The decision will be based, in part, upon your current tax rate and a general forecast of your future tax rate and financial situation.

Typically a tax preparer or CPA will have a short-term, year-to-year view of your tax situation. They will almost always try to reduce the taxes paid in the current year. This means the tax preparer may be hesitant to complete a Roth conversion because it will increase the taxes you pay in the current year.

A financial advisor should be utilizing strategies to reduce your taxes over a longer time horizon. Although a Roth conversion will increase taxes now, it is a strategic move to potentially lower the total dollar amount of taxes paid in your retirement or lifetime.

Both components of financial/tax planning are important, so it is hugely beneficial to have two professionals working toward the same goal, your financial security in the future.

You will probably complete this strategy over a period of several years, making a Roth conversion each year until the entire balance of the Traditional IRA is converted. This will allow you to take full advantage of the marginal income tax bracket in which you fall in a given year.

This process isn’t for everyone. There are definitely circumstances where it is beneficial to leave funds in the Traditional IRA. You can consult with your financial advisor to determine whether a Roth conversion would be something you should consider at the end of this year or in any future years.

Qualified Charitable Distributions

You can make gifts to a non-profit organization directly from the investment/retirement account. This is known as a qualified charitable distribution or QCD.

If you are already in retirement and have a charitable mindset, qualified distributions are a great tool. You shouldn’t complete charitable actions for the purpose of saving in taxes, the math doesn’t really work in your favor. Some would say, “Don’t let the tax tail wag the giving/charitable contribution dog.” I’m not in love with the analogy, but you get the point.

If you already have generous intentions and want to take advantage of any tax strategies to maximize your giving, QCDs could be a great tool for you.

This happens to be one of the reasons you may choose not to complete any Roth conversions leading up to and during retirement. If you will be directly giving funds to a charitable organization via QCD, you won’t need to pay taxes on the amount donated anyway. Because of this, you’ll be better off leaving the funds in a pre-tax, Traditional IRA.

You are required to withdraw funds from a Traditional 401k and/or IRA at age 72. This age is subject to change and could be pushed back to age 75 in the next few years. For now, we will continue to use the written (rather than projected) law. These are known as required minimum distributions (RMDs).

Many individuals choose to take their RMDs and turn them into QCDs. (Too many abbreviations and acronyms in financial planning, I know.)

If intentional giving is a significant component of your financial plan, the use of QCDs will impact many of your decisions. During a time of year where many people are looking for ways to express generosity, it is a great tool for individual investors and business owners.

Gifting in Alternate Years

Any gifts or charitable contributions in a given year are tax deductible. This means you can subtract the total amount of your giving from your taxable income.

Ironically, many people carefully track their giving/charitable activity and never use any of the corresponding deductions. This is because the IRS/US government provides individuals/households with a standard deduction. In 2022, the standard deduction is $12,950 for single taxpayers and $25,900 for married filing jointly taxpayers.

The standard deduction typically determines whether an individual and/or family should “itemize” deductions, meaning you will go line-by-line to subtract the donations from your taxable income. You will only itemize if your total deductions exceed the standard deduction.

The standard deduction is relatively large, even for those individuals/families with a high taxable income.

“Gifting in alternating years” simply means stacking deductible giving into a single year instead of spreading it out over several years.

In the year with stacked charitable giving, you will exceed the standard deduction which will further decrease your taxable income and ultimately reduce your tax bill. In the other years, you will simply utilize the standard deduction.

The most simple form of this activity would be pre-paying any giving you had planned for early next year, if possible. You will pull those donations into the current tax year and increase the likelihood you will exceed the standard deduction, use any charitable deductions, and lower your income taxes.

It is a simple, useful strategy you may consider utilizing as the end of the year (and the opportunity to take action) quickly approaches.

Contribute to a 529 Plan

The 529 Plan is an account/tool to pay for education expenses. You can contribute to the plan and deduct any contributions in many states to potentially reduce your state income taxes. If the withdrawals are used to pay for a qualified education expense, you will not pay any federal taxes on the back end.

Anyone can open and fund a 529 Plan - the student, a parent, a grandparent, and even other friends/relatives.

If you have children who haven’t quite reached college age, you may already be familiar with the 529 Plan and its benefits.

You may not know about how a 529 can be utilized before your child reaches college. If a child attends a private school for their elementary or secondary education, you can use the account to pay for this tuition as well. Since you were already footing the tuition bill anyway, the 529 simply creates a tax deduction or credit at the state level.

If education is a high priority for you/your family and there is an intention to help fund a child's education, the end of the year is a great time to contribute to a 529 Plan.

___________________________________

TL;DR

These end of year tax strategies are relatively simple. Will any of these be life changing when accomplished in a single year? Probably not.

When you work with a financial advisor, the goal should be to reduce your “Total Lifetime Tax Bill” so completing any of these strategies helps to accomplish this worthy goal.

Pay your required share but not any more. They don’t give out any awards for paying extra taxes.

___________________________________

Do you hate paying taxes as much as the rest of us? Just a knowledge drop today, but we can commiserate about our future tax bills.