We are in the middle of baseball season, and one of my favorite summertime activities is cheering on our local Billings Mustangs at Dehler Park. Even if it’s not the “big leagues”, it’s still a joy to watch all of the young and upcoming players put their skills to the test in hopes of a chance of moving up the ranks in the minor leagues and potentially even the majors. It’s no doubt that the players who consistently play have put in countless hours. Many of these hours being in the offseason.
It can be easy to think of “tax season” as a once-a-year event that happens each Spring and culminates with the joyous feeling of getting a refund, or the burden of finding out you have to send in more money to the IRS. Whatever the feelings you have experienced at tax time, a proper tax plan should be executed throughout the year, not just when we pay taxes. If you’re a high earner, it can be even more exaggerated, with more surprises than you might not want or be ready for.
In this post, we will explore the various ways to plan for a smoother and more predictable tax planning experience, including 6 ways to reduce your eventual tax bill.
Tax-Loss Harvesting
Tax-Loss Harvesting is a fairly simple strategy in theory, yet can be complex in its execution. If not done properly or in the right type of account or with the right investments, there can be various unintended consequences. However, if done properly, generating even just a few thousand dollars of deductions against ordinary income can be worth the time and effort.
There are two main criteria to satisfy when it comes to implementing a successful tax-loss harvest(TLH). First, the TLH must be done in a non-retirement account. Individual, Joint, and Revocable Trust are the three most common account types that are good candidates for an effective TLH. Ensuring the TLH is done in a non-retirement account such as the three listed above allows for the losses to be offset against both capital gains and other types of income, up to the IRS maximum. This includes using the loss against ordinary income, which is taxed at higher rates. If you are in a high tax bracket, even a $3,000 loss against your ordinary income could result in over $1,000 in tax savings.
The second component to a successful tax-loss harvest is ensuring that the Wash Sale Rule is not triggered. The Wash Sale Rule is made up of two elements. First, you need to ensure you are replacing the security you are selling with one that is not “substantially identical” to the one you are selling. There are no hard and fast rules to this definition, but working with a qualified financial and tax advisor can help to make sure you are on the right track with the transaction. Second, the replacement security must not be bought within the 61 day window as defined by the IRS. If the replacement security is purchased within this window, the loss is disallowed and is deferred to the basis of the replacement security.
If possible, it is best to use investments that currently have short-term losses, as opposed to long-term losses. Short-term losses are the first to be used against short-term gains, if any. Since short-term gains are taxed as ordinary income, short-term losses are the most “valuable” losses to use when offsetting gains or other income.
Don’t Forget Your Spouse
If you’re married, taking advantage of your spouse’s tax opportunities present another way to reduce your tax liability. Specifically, if one spouse is working and the other is unemployed, or otherwise doesn’t have access to an employer-sponsored retirement plan, the non-working spouse will have greater access to fund a deductible IRA. Under 2024 rules, the income phaseout limits for the employed spouse begin at $123,000 while the limits for the unemployed spouse don’t begin until $230,000. This allows for the unemployed spouse to still contribute to an IRA and get a tax deduction for the current year, even if the working spouse is not eligible.
Another opportunity for a non-working spouse is the ability to fund a Roth IRA. If 2024, if your household gross income is less than $230,000, the non-working spouse can also make a full contribution and take advantage of the long-term tax-free growth potential of a Roth IRA. While contributing to a Roth IRA won’t reduce your tax liability for the current year, making a Roth IRA contribution allows you to shelter money that otherwise might be subject to taxes in the future.
Contribute More to Your Employer-Sponsored Retirement Plan
If you are employed or self-employed and have access to an employer-sponsored retirement plan, contributing more to your retirement plan can help to reduce your tax liability. In 2024, the contribution limit for 401(k) and 403(b) plans is $23,000. This limit increases if you’re over 50, which we’ll discuss later on. If contributing more to your retirement plan is possible, keep in mind that the increased contributions must come from your ongoing payroll deductions. So, planning out your annual increase as early in the year as possible will allow you to spread out the deductions over more of the year. This helps to lessen the impact on your take home pay over more pay periods.
If you’re self-employed and are only contributing to a Traditional IRA, consider setting up a retirement plan with higher contribution limits. Not only will this give you more options for investing for retirement, but it will also help to lower your tax burden. A few of the different plan options for self-employed individuals include 401(k), SEP IRA, or SIMPLE IRA. While SEP and SIMPLE IRAs are more straight forward and standardized, a 401(k) plan allows you to customize the plan to the needs of the business and you as the business owner.
Contribute to a Health Savings Account
Many people are aware Health Savings Accounts offer tax benefits, but few understand all of the tax benefits of an HSA. While the money in an HSA grows tax-deferred and can be taken out tax-free for qualified withdrawals, the contribution someone makes into an HSA is also tax-deductible. In this way, you can receive both an immediate and a long-term tax benefit from contributing to an HSA.
When deciding whether to set up or contribute to an HSA, it is important to remember that there are IRS guidelines that determine your contribution eligibility(aren’t there always?). The IRS dictates that you must be enrolled in a High-Deductible Health Plan. Not only does this determine if you can contribute to an HSA, but it also stipulates how much you can contribute. In 2024, the HSA contribution limits are $4,150 for Individual Coverage and $8,300 for Family Coverage.
Keep in mind that, in addition to the tax benefits, HSAs allow you to use the funds in them for a wide variety of medical expenses. And since the funds don’t expire like they do in a Flexible Spending Account, you can continue to grow the funds in your HSA, even if you don’t have medical expenses in the year that you make the contribution. In this way, you can continue to receive a tax deduction for the contributions you make, even if you don’t have medical expenses that you are distributing the funds for.
Don’t Forget the Catch-Up
One of the great things about investing for retirement in the right types of accounts is that the IRS allows for a greater amount of contributions as you get older. As I mentioned before, both IRAs and employer retirement plans allow for greater contributions to them once you turn 50. For 2024, the amount of the catch-up contributions ranges anywhere from $1,000 to $7,500, and even more if you’ve been with certain types of employers for 15 years or longer.
The catch-up contribution presents a great opportunity to not only super-fund your nest egg as you near retirement, but it also allows you to deduct the amounts from your taxes in your peak earning years. If you and your spouse are both working, make sure to take advantage of these additional contribution limits before retirement.
Make Tax Smart Gifts
While everything we’ve talked about to this point involves saving and investing for your own future, there are other ways to save on taxes while also benefiting others. It’s no secret that I am passionate about giving, and being able to get a tax benefit at the same is a win-win in my book.
When it comes to the world of giving, one of the most favorable rules in the tax code is for Qualified Charitable Distributions(QCDs). If you’re over 70 ½, QCDs allow you to exclude gifts to charity from your income, allowing you to gain a double tax benefit from your IRA, and effectively never having to pay tax on the money that you charitably give from your IRA. Further, if you are nearing age 73, QCDs also satisfy your Required Minimum Distribution, effectively reducing or even eliminating a distribution that would normally be taxable.
A second way of making tax smart gifts is through the use of a Donor-Advised Fund(DAF). This allows a donor to set up a pool of money that can be granted to non-profit organizations. However, the donor gets to control both when and how much gets put in and also distributed from the DAF. Because of both the flexibility and control, a DAF can be a powerful tool for charitable giving and tax efficiency.
Third, one of the best ways to give to charity is by transferring investments directly to your charity of choice from a non-retirement account. In most cases, you might qualify to get a deduction on the market value of your investments and avoid having to pay the capital gains tax on any appreciation that the securities have generated. This also creates a win-win for both the tax savings and charitable accomplishments.
For a more in depth explanation of these tax-efficient ways of giving, check out our blog post on 3 Tax-Efficient Tithing Strategies for Charitable Giving.
In summary, just like a good baseball player who trains in the Fall and Winter, a good tax season involves a good “off season”. By purposefully taking steps to prepare for the future, you will be much more ready to have a good tax season when Springtime rolls around. If you’re not working with an advisor who helps you plan for your taxes in the off season, get in touch with us today.
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