Leveraging the Tax Code to Minimize Your Tax Liabilities – Kiplinger’s Personal Finance

As we head toward March, one of most dreaded times of the year approaches: tax season. Right now is the time when you’re inundated with tax documents, including a W-2 from your employer, 1099s from your side gigs, 1099-MISC statements from your online brokers, 1099-Rs for retirement income and more.

There isn’t much you can do now to reduce your 2021 tax obligations outside of contributing more to tax-deferred retirement accounts. That’s why the beginning of the year is the perfect time to adopt new strategies to minimize your tax obligations for 2022.

All too often, your focus is on the rearview mirror – what you’ve already done and what you’ll have to pay. Instead, when you shift your focus to a proactive stance, you’ll reap the rewards throughout this year and into 2023, when you’ll file your taxes for this year.

As an enrolled agent – a professional who has earned the privilege of representing taxpayers before the Internal Revenue Service (IRS) – and a financial adviser, there are three strategies that I’ll share with you that have the potential to reduce your taxes in coming years. Of course, every situation is different and you may have other factors that cause your taxes to increase even if you adopt these and other tax mitigation suggestions.

Strategy #1: Maximize your tax-deferred retirement contributions

One of the most effective ways to reduce your tax liabilities is to increase your contributions to tax-deferred retirement vehicles, such as company-sponsored 401(k) or 403(b) accounts, government-sponsored Thrift Savings Plans (TSPs) or individual retirement accounts (IRAs). If you’re like many people, you’ve got room to increase your contributions before you hit the maximum allowable contribution.

If you’re in a 401(k) or 403(b) account, that limit is $20,500 for 2022. If you have a SIMPLE account, the limit is $14,000, while the limit for a SEP IRA is $61,000. If you are turning 50 in 2022 or are already older than 50, you can sock away more due to catch-up contributions, which are $6,500 for 401(k)s and 403(b)s and $3,000 for SIMPLE IRAs. There are no catch-up contributions allowed for SEP IRAs, because contributions can only be made by employers not employees.

For traditional tax-deductible IRAs, which are accounts that you establish for yourself, contribution limits are $6,000 a year with $1,000 extra allowed for catch-up contributions for those turning 50 and older in 2022.

Approaching your tax-deductible retirement plan contributions for the entire year in a strategic manner allows you to maximize your contributions while minimizing the impact on your budget. Here’s an example illustrated in Figure 1: Let’s say you want to increase your 401(k)contribution by 50%. If you can divide that over 26 pay periods, those additional contributions will be spread over a longer period of time, meaning that each contribution will be smaller than if you decided to take this action in the summer or in the fall, when you’d have fewer weeks remaining in the year.

Figure 1: Impact of a 50% increase in 401(k) contribution at different times of the year

Initial contribution Additional contribution Total new contribution 26 Pay Periods 13 Pay Periods 7 Pay Periods
$5,000 $2,500 $7,500 $96.15 $192.31 $357.14
$7,500 $3,750 $11,250 $144.23 $288.46 $535.71
$10,000 $5,000 $15,000 $192.30 $384.62 $714.29
$12,500 $6,250 $18,750 $240.38 $480.77 $892.86

You can see how starting early in the year offers a considerable advantage. In this case, increasing your contribution by $2,500 a year would only take additional payroll deductions of $96.15, assuming you’re paid every other week. Even if you wanted to increase your contributions by $5,000, you’d be left with a manageable deduction of $192.30 a week. However, the longer you wait, the higher the hill that you’ll have to climb in terms of the amount you have to contribute per pay period.

The more you contribute, the larger your tax savings, since 401(k), traditional IRAs, SEPs and SIMPLE IRA contributions are made with pre-tax dollars. Think of this strategy as a win-win, because not only do you save money on your taxes today, you’re also building a nest egg for tomorrow, when it’s time for you to retire. Of course, you will have to pay taxes on your contributions when you take money out in retirement.

Strategy #2: Invest in stocks with qualified versus ordinary dividends

Qualified dividends are taxed at more favorable capital gains tax rates, in contrast to ordinary or nonqualified dividends, which are taxed at ordinary income tax rates. Capital gains tax rates are 0%, 10%, 15% or 20%, in contrast to ordinary income rates, which can be as high as 37%.

Generally, if you hold dividend-paying stocks in taxable accounts – not retirement accounts – you’ll pay taxes at the qualified dividend rate, as long as you hold shares in the company that issues those dividends for more than 60 days during the 121-day period that starts before the day that a company’s dividend is recorded, which is also known as the ex-dividend date.

While this definition may seem complicated, there is method to the IRS’ madness – the intention of Congress was to reward long-term shareholders with a lower qualified dividend rate. This is why you must hold stock for a period of time to receive the preferential dividend rate.

The definition of an ordinary dividend, in contrast to a qualified dividend, is a dividend from certain types of stocks, such as real estate investment trusts (REITs) and master limited partnerships (MLPs). In practice, those stocks may have dividends that are taxed at lower effective rates, but there are many different factors that play into this distinction that are beyond the scope of this article.

In addition, money market funds and dividends paid by employee stock option plans are also ordinary dividends. Fortunately, you don’t have to do the math or know which is which as those will be automatically categorized on your tax statement by type.

To get around these issues and minimize your tax liabilities, it can make sense to hold qualified dividends in taxable accounts and stocks and other instruments with ordinary dividends in tax-deferred accounts, like qualified retirement plans, or in non-taxable accounts, like Roth IRAs.

Strategy #3: Consider investment-only variable annuities

Frequently overshadowed by other types of annuities, investment-only variable annuities offer an option to save money on a tax-deferred basis beyond other tax-deferred vehicles, such as 401(k)s or traditional IRAs. Unlike many other types of variable annuities, which have gotten a bad rap because of their high fees and complexity, investment-only variable annuities are fairly straightforward, provide a wide variety of investment options and carry reasonable fees.

An advantage of investment-only variable annuities, especially compared to 401(k) funds, is the wide variety of investment options available. These can be used to diversify retirement assets, as many 401(k) plans offer limited options in a few asset classes. You can use an investment-only variable annuity to invest in alternative investments or in asset classes that might not be offered within your company-sponsored retirement plan.

Investment-only annuities aren’t suitable for everyone. If you haven’t maxed out your company-sponsored retirement accounts, there’s not much sense in investing in this type of vehicle. However, if you have maxed out your company-sponsored retirement accounts and are looking for another place to stash savings that you can use to get a tax deduction, it might be worthwhile considering an investment-only annuity.

Like other types of annuities, investment-only annuities don’t offer liquidity. In other words, if you’re likely to need the money you’ve saved before you turn 59½, you shouldn’t invest in this type of annuity, because you’ll have to pay a penalty of 10% if you take the money out early.

In addition, contract language for annuities is quite complex and some of the provisions can be difficult to understand. Fees vary widely, so be sure to investigate all your options before committing to one of these products.

Securities and advisory services offered through Registered Representatives of Cetera Advisor Networks LLC (doing insurance business in CA as CFGAN Insurance Agency LLC), Member FINRA / SIPC, a broker/dealer and Registered Investment Advisor. Cetera is under separate ownership from any other named entity. Investment advisory services may also be offered through HBW Advisory Services LLC. LHD Insurance & Financial Services, HBW Insurance & Financial Services, Inc. dba HBW Partners and HBW Advisory Services LLC are separate entities, which do not offer legal or tax advice. CA Insurance license: 0C63007
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This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

Bulent Erol, Financial Adviser, Enrolled Agent

Principal, LHD Insurance & Financial Services

Bulent Erol is the principal in the firm LHD Insurance & Financial Services and is a 30+ year veteran of the financial services industry. Prior to starting his own financial services firm, Bulent worked in a variety of field and executive positions with Price Waterhouse, AXA and Merrill Lynch. He is an Enrolled Agent and holds the “Chartered Federal Employee Benefits Consultant” designation. He finished the curriculum for the Certified Financial Planner designation.