It’s getting to be that time of year. No, this is not about figuring out how big the turkey needs to be to ensure leftovers or getting holiday decorations out of the garage. This is the topic no one wants to think about and will make us want to kick ourselves six months from now if we ignore it.
We are talking about taxes. More specifically, we’re talking about tax planning. Between now and the end of the year, you could potentially reduce the taxes you will owe next April. Or, you could take steps now to reduce taxes far into the future. In the spirit of not putting things off until the very last minute, we offer these nine tax planning tips while there is still time to act on them.
#1 – Harvest tax losses to offset gains, and vice versa.
If you have realized gains in your portfolio this year, see whether you have some holdings worth less than what you paid for them. Many investors are reluctant to sell anything at a loss since it can feel like admitting a mistake, but this situation presents an opportunity to reduce the taxes you would owe on your gains.
Similarly, if you have generated losses this year, it can make sense to “use” them to reduce taxes on capital gains. You may have been putting off selling certain positions even if they now represent an oversized share of your portfolio to avoid the tax bill for the gains you would realize by selling. You can use realized losses to offset gains, thereby reducing your tax bill.
Ask your financial advisor or tax professional for input on this before proceeding because there are rules about matching short-term gains and losses versus long-term gains/losses. As you likely know already, short-term simply means that you held the position for less than one year.
# 2 – Make a (backdoor?) Roth contribution.
Roth IRA contributions are a good idea for almost everyone who has earned income this year (if you are retired, this is not for you). Contributing to a Roth will not reduce this year’s taxes, but you pay no taxes when you eventually take withdrawals from the account. Money contributed to a Roth today could triple or quadruple in 20 years, adding up to tremendous tax savings.
You can contribute directly to a Roth IRA only if your modified adjusted gross income is below a specific limit; in 2021, the limit is $140,000 for individual taxpayers and $208,000 for married couples filing jointly. If you meet that requirement, the maximum you can contribute is $6,000 per year and $7,500 if you are over age 50.
If you exceed the income limit and have a traditional IRA, you could do a straightforward Roth conversion. This involves taking money out of your traditional IRA, paying taxes on that money today, and then putting the remaining funds into a Roth IRA.
If you do not have a traditional IRA and your income exceeds the limit for making a direct contribution, a Backdoor Roth IRA contribution is worth considering. In this strategy, you establish a traditional IRA, contribute to it, and convert it to a Roth IRA. As part of this conversion, your contributions are taxed. Again, this does not reduce your taxes this year, but it offers tremendous potential for tax-free appreciation going forward. Furthermore, you should confirm the proper execution of this strategy given your circumstances with your CPA or financial planner since making a mistake can have a significant negative impact.
With Roth IRAs, you are not required to take withdrawals at any particular age, and you owe no taxes on any of the distributions. If you inherit a Roth IRA or expect to leave money in your Roth IRA to your heirs note that annual minimum distributions are required, but the distributions are not taxed.
What about a Roth 401(k)? Suppose your employer offers a Roth 401(k) option. In that case, it is generally a good idea to contribute after contributing enough to a regular 401(k) to earn the maximum amount your employer is willing to match. Side note: An employer can contribute to a Roth 401(k), but they will be taxed as ordinary income when you take withdrawals from the account. You must withdraw money from a Roth 401(k) annually starting in the year you turn age 72 (70 ½ if you reach 70 ½ before January 1, 2020) even though the withdrawals are not taxed.
The following three tips reduce your tax bill while meeting charitable giving goals.
#3 – Contribute to a Donor-Advised Fund.
A Donor-Advised Fund lets you reduce your taxes this year while giving you many years to choose which causes you wish to support and when you want to distribute the funds. To take full advantage of the tax benefit, “front-load” your DAF contributions – in other words, put two or more years’ worth of charitable donations into the DAF this year; enough so that you meaningfully exceed the standard deduction for tax purposes and can therefore itemize your deductions to reduce your taxes.
Here’s an example: Let’s assume Joe pays $10,000 in mortgage interest this year, his only deductible expense. He would not itemize his taxes because the standard deduction of $12,550 is higher than his itemized expenses. If Joe gives $2,550 to charities this year, he will not itemize because it would not give him any tax benefit. But, if he “doubles up” and contributes two years of charitable contributions to a donor-advised fund this year ($5,100), he would then itemize his deductions of $10,000 + $5,100 = $15,100, reducing his taxable income by $2,550. Joe could then dole out money from the account to whichever charities in whatever time frame he wants because the contributions were already “made” in the eyes of the IRS.
Important: Donate shares of stocks, bonds, mutual funds, or ETFs that have appreciated and avoid paying capital gains taxes on the gain, a tax benefit even if you do not itemize. These positions must be long-term, and, naturally, the individual tax lots with the most appreciation provide the most benefit.
#4 – If your assets exceed the estate tax threshold, consider a charitable trust.
If you have substantial assets and would like to donate a significant amount to charity in the future, there are two types of charitable trusts you may want to consider, a Charitable Lead Trust (CLT) and a Charitable Remainder Trust (CRT).
With a CLT, assets are placed into the trust, and income from the trust is donated to charity. You receive a tax deduction today based on the value of the income to be donated to charity. Assets that remain in the trust at the end of a designated period can be disbursed to other beneficiaries or held in the trust. This can be a great way to transfer wealth to your heirs while providing consistent cash flow to the charity of your choice.
With a CRT, you or your designated beneficiaries receive income from the trust, and assets remaining in the trust after a specified period are given to the charity of your choice. This can be a great solution if you have highly appreciated investments and want to generate income for yourself while providing for charitable giving.
#5 – Reduce the tax hit from selling your business.
If you expect to sell your business soon, you could donate some portion of your ownership shares to charity, reducing the taxes you will then owe on the sale proceeds. Your Gold Medal Waters advisor can bring in experts to discuss how this could work in your situation. Note that restrictions on the types of entities that can legally own a medical or optometry practice may make this infeasible for medical professionals selling a practice.
#6 – Invest in opportunity zones - Opportunity zones were created by the Tax Cut and Jobs Act of 2017.
Taxpayers can invest capital gains into designated opportunity zones, deferring taxes on those gains until the investment in the opportunity zone is sold or December 31, 2025, whichever is earlier. Any income earned on these investments is not taxable. If this sounds appealing, consult with your GMW advisor, and we will bring in the appropriate tax experts to discuss the specifics.
#7 – Use the gift tax exemption.
Those with sufficient wealth can reduce the size of their future taxable estate by gifting up to $15,000 per year to any individual, tax-free. These gifts do not reduce your taxes, but the recipients do not have to pay taxes on the money, and you can enjoy seeing the impact of your generosity while you are still around! You can think of it as giving today some of what you would otherwise leave to your heirs many years from now.
Also, note that some states, including Colorado, offer a state tax deduction for 529 plan contributions – that applies to parents, grandparents, or anyone else who contributes. So, your gift-giving could give you a state tax deduction, depending upon where you live.
And, if you are already retired...
#8 – Use your Required Minimum Distribution to fund charitable contributions.
If you plan to give to one or more charities this year, it makes sense to use your RMD to make those contributions, especially if you do not itemize your deductions. A “Qualified Charitable Distribution” from an IRA satisfies your RMD and provides a tax benefit that you do not get when you make charitable contributions from cash. The money must flow directly from your IRA to the charitable entity(ies), or the IRS won’t let you count it.
#9 – Consider tax impacts of inherited IRAs on your heirs.
The beneficiary must withdraw the money in an inherited traditional IRA or 401(k) within ten years of the date the account was inherited (kindly note that spouses of the deceased are given different preferential rules). Since these withdrawals are taxed as ordinary income, one school of thought says retirees should meet their spending needs from these accounts first to minimize the amount left to heirs that will be taxed at high rates.
Another point of view says retirees should draw upon their taxable accounts first to allow tax-deferred accounts to grow tax-free for longer. The right approach for you depends partly on your current tax bracket compared to what your heirs’ tax brackets are likely to be when you pass – a difficult prediction to make. Discuss this with your GMW advisor to determine what is appropriate for your situation.
Our last bit of advice on this topic: don’t look for ways to avoid paying taxes altogether, because generally speaking, those so-called “strategies” are not legal! Reach out with any questions.
