By Scott Danek, Founder, CERTIFIED FINANCIAL PLANNER™ and GFN (Genuine Fishing Nut)
Obviously no one wakes up in the morning and says “I want to pay more in taxes than I should”, but inaction and a lack of a proactive, experienced advisor working on your behalf can cause that to occur. With the right tools, systems, and processes in place you can tilt the scales (legally) in your favor rather than just gritting your teeth and writing that check to the IRS. Here are five strategies that should be included in your tax planning as part of a process that involves steps that occur along the way, throughout the year, rather than just in that month or two leading up to filing your return.
Strategy #1 – Tax-Loss Harvesting
Some think of this as a once a year ritual in November or December, and we do that as well. But, what happens when the stock market sells off in the middle of the year, or early in the year like it did in 2020 when COVID hit? Sure, you’re not happy the market and your accounts are down, but let’s make some lemonade out of those lemons by proactively selling some of the securities in your non-retirement accounts to ‘book’ those losses. Then later you can use them to some extent to lower ordinary income or offset future gains. This is why we reached out to so many of our clients during this time when that opportunity presented itself, as we like the ‘Penny Saved is a Penny Earned’ expression.
Strategy #2- Fund But for Now Don’t Spend Your HSA Account
If you are covered by a high-deductible health care plan you likely can contribute to an HSA, or Health Savings Accounts. We find often people are spending this money on a year-by-year basis even though their cash flow could allow them to pay out-of-pocket instead. You may ask, isn’t this the point of the account? In a way yes, but it means you are spending your own money for health care costs. What if instead you funded it, but didn’t touch the HSA account until retirement? You’ll surely have medical expenses then too. Now let’s assume you have 20 or more years to have that money be invested in your HSA account before using it. If you only get a 3.6% rate of return on that money during that 20 year period your contribution today would double. Then you are using gains to pay for at least some of your medical expenses. Yes!
Strategy #3 – Avoiding Mutual Funds for Non-Retirement Accounts
This one is related to #1. If you own a mutual fund, let’s say half the stocks in it are down and half are up at the end of the year when you want to do tax-loss harvesting. If they just happen to be up and down an equal amount the fund will be ‘flat’, meaning neither up or down. If you sell your fund you wouldn’t realize a loss or a gain, so why bother, right? True, which is why we don’t use mutual funds for our non-retirement accounts. Instead, we use a different structure that still provides broad diversification, stock and bond ownership, professional management, etc. The difference is we can go in and sell only those securities that are down at the moment on a security-by-security basis. Imagine weeding your precious flower bed with a pair of handheld nippers instead of a weed whacker. Which is going to allow you to only prune your weeds while saving your beautiful flowers? Exactly.
Strategy #4 – Take Money in Retirement from IRAs Before You Have To (Which is now A72 per SECURE Act)
Another way to take your tax planning to the next level is pay income taxes before you have to. That big space there was to allow you to recover your senses after reading that sentence. Your first reaction was likely ‘What is this guy talking about. . .’ and that is a very understandable reaction. There are however a couple instances when it is advisable to take distributions from your IRAs in retirement before you must. One is if doing so allows you to pay tax in a ‘low bracket’ due to your sources of retirement income, pulling down the value of your IRAs so that your ultimate RMDs (Required Minimum Distributions) are taxed in a lower bracket than they would if you’d completely put off those distributions.
Another is Roth Conversions. A change in tax law related to your beneficiaries per the SECURE Act dictates many people should look at whether converting some or all of their pre-tax IRAs should be converted to Roth IRAs. In this case, when Cinderella’s slipper fits and this strategy is appropriate it can increase the net amount that the kids receive by tens if not 100’s of thousands of dollars. Especially if your kids are well on their way to having great careers and earning a good living on their own this is something that should at least be analyzed as part of your tax planning.
Strategy #5 – Let Your IRA Make Your Charitable Contributions
If you are 70 ½ and older and you give money to your church, or other charities, you could either write a check or have your IRA do that for you. If it goes directly from your IRA it is like the income/distribution never happened to you (think no attempt to deduct, itemize, messy forms, etc.) and your charity (ies) will still benefit from your generosity. This is called a QCD, or Qualified Charitable Distribution, and we do many of these each year for clients. In some cases clients literally give us a list of $200 ‘here’ and $300 ‘there’ and so on. If this is news to you we need to chat and see if you are missing an opportunity to reduce the cost of your helping to make the world a better place.
Bonus Strategy – There are many other opportunities to save taxes by way of proactive, year-round tax planning but it can be difficult to find the time to do the research necessary to identify appropriate strategies. This was even the case for us, until we gained access to a great program that allows us to quickly and efficiently identify opportunities for clients. With a scanned copy of a return we can have a report turned around in under 24 hours, so this is time well-spent considering in some cases (think #2 above) there can be decades of good done with a simple change of course.
So, if you are thinking your tax planning needs to be more pro-active, and some of these strategies sound like something you should at least understand better than a quick blog allows, give us a call. We know you’d still prefer to find yours™, meaning travel, spoil the grandkids, improve your golf game, fish more, so having a proactive, year-round approach to your tax planning that doesn’t cost you a lot of time but adds a lot of value would help you do that.
We look forward to the discussion (and helping you find yours. . .™).
This example does not reflect sales charges or other expenses that may be required for some investments. Rates of return will vary over time, particularly for long term investments. Converting from a traditional IRA to a Roth IRA is a taxable event.