While there likely isn’t a magic bullet to wipe out your tax bill, there are ways to layer tax-efficiency into your plan. If you’re concerned about the possibility of tax rates going up or just looking to reduce your taxable income in 2021, consider these tax planning techniques.
But first: paying less tax doesn’t always mean saving money
Before diving into tax planning strategies, it’s important to remember that reducing your tax bill doesn’t always mean you’re actually saving money.
Here’s a simplified example. Assume you’re in the 37% tax bracket and donate $100 cash to charity. Your good deed shaves $37 off your tax bill. But if your only objective is tax savings, you just spent $100 to save $37. Ouch.
So, as you consider ways to reduce tax, don’t let the desire for tax savings overshadow the actual outcome. In another words, start with your existing goals then investigate tax efficiencies, not the other way around.
9 ways to reduce your tax bill
Although not an exhaustive list, here are nine ideas to reduce tax (in no particular order):
- Asset location and actual location
- Don’t pay tax twice
- Retirement income planning
- Stock option exercise strategies
- Give assets (not cash) to charity
- Take losses
- Inheritance tax planning
- Retirement plans for businesses
- Donate your RMD
Location is everything
Consider if you: have assets in retirement and taxable accounts OR are considering moving to a tax-free state.
Asset location strategies help reduce tax by taking advantage of the tax treatment in different types of accounts.
In non-retirement accounts, investors pay tax annually on dividends, interest, and capital gains. In retirement accounts, taxable gains are deferred. So all else equal, allocating income-producing assets like bonds to retirement accounts can yield tax savings. There are caveats to be aware of, though. For example, tax-free municipal bonds and tax-efficient funds generally don’t belong in retirement accounts.
What if you’re thinking of moving to a tax-free state? People are moving to Florida for more than just the sunshine. Before packing the U-Haul, discuss your thinking with a tax advisor. For example, if you have stock options, you may owe tax to your former state of residence, even if you move before exercising.
Cut your tax bill in half by not paying tax twice
Consider if you: are making non-deductible (non-Roth) IRA contributions.
Though not technically net tax savings, non-deductible IRA contributions are double-taxed enough to warrant inclusion.
When making after-tax contributions to an IRA, you must inform the IRS that you’ve already paid tax on those dollars. This is done using Form 8606. If you don’t file the form, you lose the ability to shield part of your IRA withdrawal from tax when you take the money out.
Further, the IRS doesn’t track your after-tax basis even if you file the right tax forms. So unless you keep great records, forever, you won’t be able to prove tax was already paid.
Reconsider your retirement income strategy
Consider if you: have tax-diversified pool of assets to draw down in retirement.
The required minimum distribution age is currently 72, but it could extend to 75. While tax-deferral is usually a good thing, it’s not always the best way to go. In retirement, it may be advantageous to start tapping retirement accounts early, consider ongoing Roth conversions while in a low tax bracket, drawing on a taxable brokerage account, or a blend of each.
For example, the long-term capital gains rate is currently 0% for married couples until income exceeds $80,800. Income planning gives you more control over your tax situation for the year.
Stock options: plan then exercise
Much like Volkswagen’s sign then drive campaign, if you have employee stock options, you should plan with your advisor first…then exercise. With stock options (either incentive or non-qualified), there are different tax implications when exercising.
Depending on several factors, perhaps most notably the spread between your exercise price and the current value of the shares, the tax impact (ordinary income or possibly alternative minimum tax) can be huge.
For some early employees, one potential tax planning opportunity is an early exercise of stock options. Also common with restricted stock, properly filing an 83(b) election can be instrumental in minimizing ordinary income (perhaps to zero), in favor of long-term capital gains tax rates.
There’s a lot more to consider before exercising stock options, which is why you need a plan before doing so.
Donate appreciated stock
Consider if you: are charitably inclined and have appreciated assets in non-retirement accounts.
When you make an irrevocable donation to a donor-advised fund, you receive an immediate charitable tax deduction for the fair market value of the asset. Donating the asset instead of selling it and giving cash means you don’t incur capital gains tax on the appreciation.
You control over which 501(c)(3) charity receives the donation and when. Individuals experiencing a windfall after selling a business or from stock options after an IPO may also want to consider this strategy in high tax years.
To benefit, taxpayer must itemize tax deductions (consider bunching charitable donations in one year if you don’t normally itemize). A charitable deduction may be taken for the full fair market value of the asset, up to 30% of adjusted gross income. There is a five-year carry forward for unused deductions. Only long-term securities are eligible.
Cut your losses
Consider if you: have unrealized losses in a taxable account and a large taxable gain.
If you have a large taxable gain one year, it may be worthwhile to consider if you have any losses to reduce the tax impact. To estimate possible tax savings, first net short-term gains and losses and long-term gains and losses separately. Then, net the resulting short and long-term figures. This gives you a combined net short or long-term gain or loss.
A net loss for the year can be deducted against your regular income up to $3,000 (or $1,500 for married filing separately). Any remaining losses over this limit can be carried forward to future years. Beware of wash sale rules.
Tax-loss harvesting doesn’t make sense in every situation. The strategy is often most advantageous when there are other reasons to sell the security, other than for tax purposes.
Inheritance tax planning
Consider if you: inherited a retirement account or taxable asset from a parent, friend, or non-spouse relative.
Starting in 2020, most adult children inheriting an IRA or other retirement account from a parent will only have 10 years to take the money. There are no distribution requirements during the 10-year period, which poses a planning opportunity.
Although this is a contested part of the tax code, currently, when non-retirement assets are inherited (perhaps in a brokerage account or living trust), the beneficiary generally receives a step-up in cost basis. A stepped-up basis increases the value of the asset for tax purposes to the market value at the time of death.
Any subsequent gain is considered a long-term capital gain. This is important, as you may have the ability to reposition or draw from the account with little to no tax impact.
Eligibility for a stepped-up cost basis depends on the type of asset inherited, ownership at death, and state laws. Assets owned in an irrevocable trust likely won’t receive a step-up in basis. This can get very tricky so it’s important to work with the estate planning attorney settling the estate.
Start a retirement plan for your business
Consider if you: are a business owner without a retirement plan.
Whether you’re a solopreneur, small business owner, or working on a side hustle, there’s a retirement plan for you. One of the best ways to defer tax is by contributing to a retirement plan. The type of plan that’s best for you will depend on the demographics and cash flow of your business. And the savings can be significant.
The 2021 total funding limit (all sources) for SEP IRAs, Solo or traditional 401(k)s is $58,000. In 401(k) plans, individuals age 50+ can make an additional $6,500 catch-up contribution.
For businesses with substantial free cash flow, a cash balance pension may make sense to consider. Though less flexible than other plans and more costly to administer, a cash balance pension plan could permit business owners to exclude over $400,000 from taxable income in 2021 when combined with a 401(k) profit-sharing plan.
Work with a pension plan consultant to understand the rules, design options, and funding requirements before committing.
Donate your required minimum distribution
Consider if you: are 70 1/2 or older with pre-tax retirement money and charitable intent.
Many retirees don’t know they can donate all, or a portion of, their required minimum distribution (RMD) directly to charity using a qualified charitable distribution.
A check is sent directly from the IRA to the charity you elect. This allows the donor to exclude the (perhaps mandatory) distribution gift from taxable income in lieu of a tax deduction.
The annual QCD limit is $100,000 per account owner. The limit can exceed the annual required minimum distribution.
But wait, there’s more
The best way to optimize your tax situation depends on your individual goals and circumstances, which is why it’s important to work with a financial and tax advisor. After all, this list is hardly exhaustive: estate planning and trust techniques, non-qualified deferred compensation plans, health savings accounts, and the Section 1202 capital gains exclusion are just a few strategies that could further your objectives and offer significant tax savings under the right circumstances.
This article if for informational purposes only and should not be misinterpreted as personalized advice of any kind or a recommendation for any specific investment product, financial or tax strategy. This is a general communication should not be used as the basis for making any type of tax, financial, legal, or investment decision.