Before making a move, did you do your Tax Planning?
Reducing taxes is great, and below I have 5 ways you can squeeze-off year-end tax savings. But before we jump on any opportunity to reduce taxes, we need to clarify something. Is your objective to lower taxes NOW or LATER?
This clarification is critical and is the basis for the practice of “tax planning.” Tax planning broadens your tax perspective. Instead of scrambling to minimize taxation at the end of each year (or before April 15th of the following year), tax planning allows you to see today’s tax options compared to future tax options. When you see all your options, you can structure your income sources (as well as your estate) in the manner that minimizes the amount of tax you will ultimately have to pay.
Benefits of lowering your taxable income now:
We all know lowering your taxable income will directly result in you paying less tax this year. But here are some other areas where a reduced income will benefit you:
- Student Aid – when applying for student aid (for your child or for yourself), eligibility is based on a number of factors, one of them being income. Income is determined by AGI (adjusted gross income) which is something you can influence by participating in some of your Federal Benefits.
- Income based repayment of Student loans – your monthly student loan obligation can possibly be determined by your AGI. The lower your AGI, the lower your monthly obligation can be. Once again, participating in some of your Federal Benefits can lower your AGI.
- Ability to deduct student loan interest – If you make too much money, you could lose the ability to deduct your student loan interest. By participating in some of your employee benefits, you can lower your AGI and qualify for a student loan interest tax-deduction.
- Eligible to make IRA (ROTH or Traditional) contributions – Your ability to contribute to an IRA, or to receive the maximum tax deduction in an IRA is tied to your AGI. Lowering your AGI can make you eligible to participate in IRA, even if you’re already maxing out your TSP!
- Reducing Medicare B premiums – Medicare premiums are calculated based on your AGI from two years prior. A lower AGI now, may translate into lower Medicare premiums for you and your spouse two years from now!
The downside of lowering your taxable income now:
Do I lose anything by reducing my income this year? Possibly. Here are a few things to consider:
- Getting a Loan – Most lenders will want proof of income to determine your borrowing capabilities. By lowering your taxable income, you may not be able to show the income levels required to get a certain loan amount.
- Restricted Funds – Money that you put into certain accounts may lower your taxes but also may come liquidity challenges. For example, money you put into your TSP is not accessible until retirement. Early access usually comes with a penalty. If you need that money in a pinch, it may not be so easy to access.
- Possible reduced Social Security Benefit in the future – This is usually not so significant, but still needs mention. Your future social security benefits are based on the amount you pay in Social Security taxes (also known as FICA). Your FICA tax is determined by your gross income. Some of your employee benefits will reduce your gross income, thus reducing your FICA tax, thus reducing your future Social security benefit.
- Increase Future taxable income – This is the classic Roth vs. Traditional question. With a Roth TSP or Roth IRA you will have tax-free income for retirement. By doing a Traditional, you will have taxable future income. This future taxable income may be taxed at higher levels, especially when you consider the next bullet point about RMDs.
- Higher RMDs in future – The IRS forces Required Minimum Distributions (RMDs) at the age of 72. These RMDs are a percentage of your Traditional account values. Thus, any money that you put into a Traditional account now, will lower your taxable income now, but will cause your Traditional accounts to grow, which may cause an even harder tax bite when the future RMD pushes your income higher than what you needed.
- Taxable income for your Surviving Spouse – When one spouse passes, the Surviving Spouse will no longer file “Joint” taxes, but will likely file taxes as “Single.” At age 72, this “single” surviving spouse will need to take RMDs from their Traditional accounts and from their deceased spouse’s accounts, too! Both of these RMDs will cause a higher income level, which in turn, will bump the “single” tax-payer’s income into higher brackets. Thus, once again, any money that you put into a Traditional account now, will lower your taxable income now, but may bite your surviving spouse harder when the RMD pushes your surviving spouses “single” income into higher tax brackets.
- Increasing future Medicare B premiums – As in the previous bullet points, any money that you put into a Traditional account now, will lower your taxable income now, but will be taxable income later. Increasing your taxable income in the future will likely increase your future Medicare premiums by thousands of dollars a year, since Medicare premiums are income based.
So, bearing the above pros & cons, here are 5 things you can do reduce your taxable income today:
- Maxing out retirement plan contributions: Have you maxed out your TSP contributions to the tune of $20,500? If not, contribute to the traditional TSP which will lower your taxable income. If you’re age 50+ you can also do a catch up contribution of $6,500.
- Maxing out HSA contributions: If you have a High Deductible Health insurance Plan (HDHP), you can max your contributions to a Health Savings Account (HSA) to lower your taxable income. The maximum is $3,650 for individual and $7,200 for self+1 or family plans. Also, If you’re age 55 you can do a catch up contribution of $1,000.
- Realizing Losses in your non-retirement accounts: Do you have any investments that have lost value? If these losses are in your non-retirement investment accounts, they can lower your taxable income. These losses are only paper losses until you sell the depreciated asset and realize the loss, so you will need to sell to capture the tax benefit. This is called “tax harvesting.”
- Claiming your empty residence as a rental property: Do you have a property that you are not living in? You can claim this property as a rental property and thus write off the expenses and depreciation as business losses.
- Claiming your side hobby as a business: If you have a side practice of buying and selling stuff, or offering a service, you might be able to claim that as a side-business and write off all the associated expenses.
- Give charity: Not like you needed incentive to be more generous, but charitable giving does provide you with tax breaks. Here are a few to consider:
- If you have unwanted required minimum distributions, you can give those as charity, and that will not be taxed as income and will satisfy the RMD requirement.
- If you were planning on giving large donations in the future, you can pre-emptively give now and reap the rewards now and later using certain charitable trusts or donor advised funds.
I hope these help!
And, if you feel I overlooked a pro or con, please let me know ASAP and I’ll modify this article!