What can I do to reduce my federal taxes before year-end?Start by knowing where you stand on income taxes now so you can take advantage of possible tax reductions before year-end and avoid surprises come April’s tax deadline.
To help lower your tax bill this year, consider taking these actions by December 31:
- Save up to the maximum in your employer’s retirement plan (if you have one).
- Apply for the American Opportunity Tax Credit or Lifetime Learning Credit if you qualify for either. (Tuition payments you make in 2016 may qualify for the credit when you file your 2016 taxes.)
- Review your portfolio to see if you have tax-loss harvesting opportunities available to reduce capital gains and possibly ordinary income.
- Make charitable gifts of appreciated securities or a Qualified Charitable Distribution (QCD), which can lower your tax bill and satisfy your charitable goals at the same time.
- Set up an Health Savings Account (HSA) and maximize your pre-tax contributions if you have a high-deductible health insurance plan (HDHP). You can use this account to pay for health care expenses now and during retirement.
What other tax considerations should I keep in mind?Figure out what you’ve already paid in federal and state taxes by checking your paystub and any other tax payments made. Have you overpaid? Underpaid? You don’t want to incur a penalty for underpaying or get too large a refund if you’ve overpaid. Remember, your refund is essentially an interest-free loan to the government. Even if you can’t make much of an impact on your 2016 tax bill, make the changes for next year.
Is there any danger in focusing my efforts strictly on reducing taxable income for the current year?Yes. If you’re contributing to traditional retirement accounts to reduce your taxable income for the current year, and delay your Social Security benefits to as late as age 70, you could see a drastic jump in your tax bill in retirement.
For example, if you maximize your pre-tax 401(k) and traditional IRA contributions (while you’re in a low tax bracket), you’re betting that you’ll be in an even lower tax bracket when you begin taking withdrawals in retirement. In retirement, you’ll be eligible for Social Security (SS) and, if you’re lucky, a pension, which in addition to your retirement plan withdrawals, could move you into a higher tax bracket and may increase your Medicare parts B and D premiums and subject more of your SS benefits to federal and possibly state income taxes.
To avoid this potential situation, consider diversifying your account types among traditional (where you defer paying taxes until it’s time to make withdrawals), Roth (where you invest after-tax money and can take qualified withdrawals tax-free), and taxable accounts (where your gains are taxed at preferred capital gains rates). Tax diversification is as crucial as investment diversification.
If I want to cut taxes in the future, what are my options?Consider planning for future tax bills by:
- Setting up an HSA. These accounts can be a valuable retirement saving vehicle because they’re “triple tax exempt”: Your contributions are tax-deductible, any growth is tax-deferred, and withdrawals are tax-free if you use the money for qualified health care expenses during retirement. You can use the HSA to reimburse your current-year medical expenses, but saving these dollars until retirement can significantly enhance your benefit.
- Determining the most appropriate order in which to withdraw assets from your tax-advantaged retirement accounts—and your nonretirement (taxable) accounts—once you’re retired.
- Contributing to a Roth IRA if you qualify, and checking if your employer offers a Roth 401(k), where no income limitation applies. If your income is high, consider processing a backdoor Roth IRA.
- Converting some or all of your traditional assets to a Roth IRA to add tax diversification.
- Delaying your Social Security benefit to get the delayed retirement credits, if you think you’ll live to your average life expectancy, which may decrease your taxable SS benefit and Medicare parts B and D premiums.
- Gifting to your family members and charity, which reduces your income, gift, and estate taxes.
How can saving in a Roth IRA help reduce taxes?The money you contribute to a Roth is taxed at your current ordinary income rate, and because you’ve already paid taxes on your contributions, you can withdraw them tax-free at any time. Any earnings you withdraw from your Roth will be tax-free, although some conditions apply: You have to hold the account for at least five years and be over age 59½. So, with a Roth, you’re basically replacing the loss of a tax deduction on your contributions now with tax-free withdrawals later. Another advantage is that, unlike with pre-tax retirement accounts, you don’t have to start taking required minimum distributions from a Roth once you reach age 70½. But keep in mind that all tax laws are subject to change.
Does a Roth still make sense if I’m already in a high tax bracket, say 28.0% or even 39.6% (the highest rate)?Right now, the marginal tax rate—the rate we pay on each dollar we earn after a certain amount as determined by the IRS—is at a historical low, which seems to support the value of Roth accounts even if your current tax rate is high. However, many people who are in higher tax brackets today will continue to be in higher tax brackets, even in retirement, and it’s unlikely that their income will put them in a significantly lower tax bracket.
So there’s no easy “yes” or “no” answer to this question, but to help you decide, consider your comfort (or discomfort) with the risk that your future tax rate may be higher than your current tax rate. Also determine how satisfied you are with the amount of tax diversification among your retirement accounts.
All investing is subject to risk, including the possible loss of the money you invest.
Diversification does not ensure a profit or protect against a loss.
Tax-loss harvesting involves certain risks, including, among others, the risk that the new investment could perform worse than the original investment, and that transaction costs could offset the tax benefit. There may also be unintended tax implications.
HDHPs have low monthly premiums and high deductibles. Because the cap on maximum out-of-pocket expense is higher, you may have to pay substantially more than someone with a lower-deductible plan if something unexpected occurs.
We recommend that you consult a tax or financial advisor about your individual situation.