Smarter tax planning is important because it allows you to keep more of what you earn and save. It doesn’t do you much good to earn a bunch of income, be disciplined enough to save it, and then watch it leak away to bad tax planning.
You can avoid this by following a two-part general tax savings framework:
- First, Do No Harm
- Take Advantage of Specific Opportunities
“The hardest thing in the world to understand is the income tax.”
– Albert Einstein
First, Do No Harm
Doing no harm means not making your tax bill higher by unnecessarily realizing income. You’ll owe taxes on the income you generate. Let’s not make it worse.
At the risk of oversimplifying, we are taxed on realized income and not net worth increases.
Let’s say you sold a product or provided a service and earned $15. You’re taxed on that income. At a 30 percent income tax rate, your net worth has increased by $10.50.
If a stock you own goes from $10 to $15, your $5 profit isn’t taxed until you sell. Your net worth has increased by $5.
Do no harm means maximizing your unrealized income and minimizing realized income as your net worth grows. It’s a key aspect of smarter tax planning.
How? By spending less and being a long-term investor.
Minimize Realized Income
You cannot minimize realized income if you constantly need money to fund your spending needs. Spending a lot means doing one of two things that will hurt. Constantly realizing income or selling investments and realizing gains to fund your lifestyle. Either way, you will not be setting up a structure to allow net worth increases to remain unrealized and untaxed.
Maximize Unrealized Income
Long-term capital gains are taxed at either 15 percent or 20 percent federally (depending on which tax bracket you are in). Short-term capital gains are taxed at your marginal ordinary income tax rate, which can be as high as 37 percent. Your state may also have a higher capital gains tax for your short-term gains. The least tax-efficient thing you can do is sell appreciated stocks within a year of purchase because then they’re taxed as ordinary income instead of as capital gains. Holding on to the investment for at least a year can reduce your tax bill by half.
Beyond that initial goal of at least a one-year holding period to qualify for long-term capital gains treatment, you can avoid further tax harm by having longer holding periods. Frequent trading in your portfolio pleases the IRS, because you realize gains and pay taxes on them. Long-term investors make fewer trades, keep their gains unrealized, and pay less in taxes. That leads to more capital being compounded, since they don’t lose a piece of the iceberg every year to taxes.
Connected to this is taking the occasional opportunity to tax-loss harvest in down markets.
Smarter tax planning means investing instead of trading. It’s important to understand the difference. When you buy a stock (or a basket of stocks), you should do so because you believe in the long-term business prospects of that company (or companies). That’s investing. Don’t buy a stock because you think you can predict a price increase. That’s trading. It’s speculative, impossible to do consistently, and tax inefficient.
Take Advantage of Specific Opportunities
Retirement plan contributions
You should start with maxing out your tax-sheltered retirement plan contributions. The retirement plan rules in our country are unnecessarily complex. There are different kinds of plans, all with their own names, which work in different ways, with different contribution limits. As an employee, it’s easier to navigate this maze, since all you need to do is make sure that you’re contributing the maximum to your employer’s plan.
Things get more complicated when you’re the employer. You need to understand (or work with someone who does) the different plans, design options, and how they work. Different plan types come with different contribution limits, different funding requirements for your employees, different costs—basically, different everything that matters.
One of the biggest planning mistakes business owners make is not designing a more sophisticated retirement plan for their business that will fit their needs and allow them to shelter more of their income. Retirement plan design is a full topic in and of itself, but for those interested, you can learn more here.
Individual Retirement Accounts
Connected to this is maximizing the use of individual retirement accounts or IRAs.
Contributions to a traditional IRA are fully tax deductible if you and your spouse are not covered by a retirement plan at work or if you are covered at work but come under certain income thresholds.
The investments within an IRA grow tax deferred, meaning you do not pay tax on the account’s annual earnings. However, when you withdraw from the IRA, your deductible contributions and earnings are taxed as regular income.
Required minimum distributions must begin when you turn 72 and can start penalty free after 591⁄2 (or earlier under certain exceptions).
Roth IRA Accounts
Contributions to a Roth IRA are not tax deductible. You can contribute to one if you have earned income or if your spouse does, but eligibility is subject to strict income limits.
Investments in a Roth IRA grow tax-free, which is a key differentiator from the traditional IRA’s tax-deferred growth. Roth IRA distributions are completely tax-free. You never pay tax on the earnings. The original owner of the Roth IRA is also not required to take required minimum distributions like they are with the traditional IRA.
If you’re eligible for both IRA types, smarter tax planning entails contributing to a traditional IRA if you think your future tax rate will be lower or the same as it is now and to a Roth IRA if you expect your rate to be higher. To maximize your wealth, it’s best to pay taxes at the lowest possible rates; if your future tax rate will be higher, you will want a tax break then as opposed to now, at the lower rate.
If you aren’t eligible to contribute to a deductible traditional IRA or to a Roth IRA, and do not already have any IRA assets, you can make what is known as a backdoor Roth IRA contribution. You make a nondeductible traditional IRA contribution, then convert the traditional IRA to a Roth IRA. Please note that this only works if you don’t have money in an IRA already. That includes traditional IRAs, rollover IRAs, and SEP IRAs. Account types you do not have to worry about are employer-sponsored retirement plans like 401(k)s, 403(b)s, and profit-sharing plans. Inherited IRAs also do not count.
Health Savings Account
Enroll in a high-deductible health plan and contribute the maximum allowed to a health savings account. There’s currently a trend toward consumerism to address the rising costs of health care. The idea is that if more people are incentivized to be smart health-care consumers, health-care costs will somehow become cheaper. This trend, while putting more responsibility on individuals, provides those individuals with a tax planning opportunity if they participate in a certain type of health plan with lower premiums and higher deductibles, although the participants face larger potential out-of- pocket health-care costs. To offset this detriment, the high-deductible plans can be paired with a health savings account (HSA) that employers and employees can contribute to.
HSA contributions are considered “triple tax-free,” meaning the contributions are made with pretax dollars, the account earnings grow tax-free, and withdrawals for qualified medical expenses are tax-free. Additionally, after the age of sixty-five, you can withdraw from an HSA for any reason but only pay tax on the gains if the withdrawals are not for qualified medical expenses. Think of it as an additional retirement plan contribution. It’s like a Roth IRA for health care, except you get a tax deduction on the way in.
Charitable gifts are tax-deductible. Smarter tax planning means making more effective charitable contributions. You could give $1,000 in cash to the local Boys & Girls Club; deduct $1,000 from your income; and if you are in the 38.8 percent combined marginal tax bracket, save nearly $400 in taxes.
If instead of donating cash, you donated shares of XYZ Corp that you had initially purchased for $500 over a year ago that are now worth $1,000, your total tax benefit would be higher. You would still get a deduction of $1,000 and realize nearly $400 in tax savings. In addition, you wouldn’t be on the hook for the capital gains tax, since the charity sells the stock. In this example, the gain is $500. Let’s say your capital gains tax rate is 23.8 percent. The tax on a $500 gain is $118. Add that to $400, and you get a tax savings of more than half of your contribution, significantly better than donating cash.
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