No one approaches financial planning with the goal of paying more taxes. Tax management, like all financial planning, is based on the premise that small changes made over time can achieve big goals. Good investment returns are important. But over the next few years, comprehensive tax management might reap even greater gains.
So don’t file your taxes in April and then forget about them for the next 10 months. By investing a little time throughout the year, you can create compounded value. The 10 techniques described here might help you lighten your tax burden.
1. Converting traditional IRA assets to Roth IRA accounts offers a chance for additional tax savings. Couples with an adjusted gross income below $100,000 can always consider a Roth conversion. Beginning this year, everyone, regardless of tax bracket, can convert. And because 2010 is also the last year of the Bush tax cuts, you can use the conversion as a way to avoid the coming tax tsunami in 2011.
2. Google “Roth segregation accounts” to understand a more complex enhancement to the conversion strategy that could earn your investments even more savings over the next two years. By segregating your Roth conversions, you can undo (or “recharacterize”) those that underperform and keep the winners. This strategy offers you 20 months to determine which accounts to keep. It’s as profitable as betting on the horse race after you know the winner.
3. With the Bush tax cut sunset, the capital gains rates are set to go from 15 percent to 20 percent. Consider harvesting some of your gains at the 15 percent rate before the end of the year so that you are not stuck paying the higher rate in later years.
4. Using appreciated stock for charitable giving can avoid paying capital gains entirely. This allows you to contribute up to 15 percent more than you could with a cash gift.
5. Check line 45 on your 2009 IRS form 1040 to see if you paid any alternative minimum tax (AMT) last year. People subject to AMT pay an average of $6,000 more than they would otherwise. AMT turns tax planning upside down. Because conventional wisdom might not apply, be sure to review your financial affairs with a professional.
6. If you have young children or grandchildren, consider funding a 529 college savings plan. Contributions in some states (including Virginia) qualify for a state tax deduction if executed before the end of the year. Up to $4,000 per account can be taken, with the remaining amount carried forward to future years. Account owners age 70 and over are allowed to deduct any amount they contribute to a 529 plan in 2009.
7. If you are a small-business owner or a freelancer, or if you have the option through your employer, consider funding a Health Savings Account. Individuals may contribute an annual tax-deductible amount of $3,050, and families can deduct up to $6,150 for contributions.
8. You may also give $13,000 per person in 2010 to an unlimited number of individuals without gift tax implications. Families interested in maximizing intergenerational wealth transfers should explore with a professional how trusts can minimize their tax burden and maximize estate planning.
9. Putting investments in the correct investment accounts can also generate significant savings. Fixed-income investments belong in traditional IRA accounts. Interest is taxed at ordinary income tax rates, but the entire value of an IRA account is taxed at ordinary income tax rates anyway upon withdrawal. Appreciating assets should be in taxable investment accounts where the growth will be at a 15 percent capital gains rate, which is likely much lower than your ordinary income tax rate. Additionally, any foreign tax paid on foreign stock investments is tax deductible in a taxable account. Finally, those investments with the greatest potential for growth belong in Roth accounts where no tax will ever be paid. This tax management alone may boost your after-tax returns by as much as 1 percent annually.
10. If you own a business, consider stashing cash in a retirement fund to reduce your tax liability. With a solo 401(k), you can contribute to the plan both as the employer and as the employee. As the employer, you can contribute either 20 percent of self-employment income or 25 percent of compensation income, depending on your company’s structure. Plus, as the employee, you can contribute another $16,000 ($22,000 if age 50 or older). Finally, for the employee portion, tax planning can help you choose between a Roth 401(k) or a traditional pretax contribution.
Although just a small part of a larger comprehensive financial plan, savvy tax management requires professional assistance. Seek the guidance of a personal fee-only financial planner and certified public accountant, fiduciaries with a legal obligation to act in your best interests. The laws and ensuing complexities are changing annually, and as a result so is the optimum path.
David John Marotta is president of Marotta Wealth Management Inc. of Charlottesville, providing fee-only financial planning and wealth management at www.emarotta.com. Matthew Illian is a wealth manager in the Richmond office. Questions to be answered in the column should be sent to questions@emarotta.com.
“9. Putting investments in the correct investment accounts can also generate significant savings. Fixed-income investments belong in traditional IRA accounts. Interest is taxed at ordinary income tax rates, but the entire value of an IRA account is taxed at ordinary income tax rates anyway upon withdrawal. Appreciating assets should be in taxable investment accounts where the growth will be at a 15 percent capital gains rate, which is likely much lower than your ordinary income tax rate.”
I thought that it was common to stash long term appreciating assets in an IRA because upon retirement, an individual could expect their reduced post-retirement income level to put them at or below even a 15% tax rate, which would make subjecting the appreciating assets to capital gains taxes (15% now, soon to be 20%) rather than ordinary income taxes a mistake…
I googled “Roth segregation accounts” and read about them. I even watched a couple of videos. It looks like I would benefit a lot getting more income in 2010 instead of 2011 and after. (I’m a small business owner who’s going to be paying a lot more in taxes next year.) My financial advisor just sells funds. And my CPA recommends to minimize taxes every year. He says the government could just decide to seize or tax the Roth accounts anyway and then I’d pay tax twice. Is that even possible?
Mike – If you understand that income taxes are at historic lows and poised to rise in the future (as we do), putting money in a traditional IRA will likely be pulled out at higher tax rates in the future as the Bush tax cuts expire. Plus, we have several clients who funded their IRAs when they were young an not making much money and now they are wealthy and paying higher taxes on the distributions. Super savers get burned by IRAs.
If you expect your tax bracket to be lower in retirement than it is today, growth stocks in deductible IRAs make sense. However, we don’t believe that this will be the case for the majority of those who are planning for their future.
The best assets to put in a taxable account are those that are growth oriented and have minimal dividend payments. Technology stocks and Buffet’s Berkshire Hathaway typically do not pay dividends. This way, you only pay a capital gains tax when you sell. Or if you leave this money to your children, you never pay a capital gains tax.
Samantha – it sounds like you need to find a CPA who does tax planning and a Financial Advisor who acts as a fiduciary. While the types of tax and financial advisors that you refer to are the most common, you can find better options if you search for them.
With regard to Roth’s being seized by the government, similar fascist actions and worse can certainly be observed when we study history – so we don’t count out this possibility. However, we tend to believe that their would be an uprising among the American people that would make this recent Tea Party activism look like child’s play if the government started seizing property.