Tax Planning

Nothing is as certain as death and taxes. While no one has control over the former, there are ways to impact the latter. Read on for several areas where careful planning can lower your tax liability, either now or in the future.

*To view current tax brackets and statuses, click here

Retirement Account Contributions

Contributions to a tax-deferred retirement account, like a traditional 401(k), lower the amount of tax you owe now. Instead you’ll owe taxes on these accounts when you withdraw funds during retirement. Ideally, you’ll be paying taxes at a lower rate when you retire. But there is a chance you’ll be at a higher tax bracket, too, so this strategy is a bit of a gamble. Even if you do end up in a higher tax bracket when you retire and start taking distributions from these accounts, you could still come out ahead thanks to gains from compound interest.

If you opt for an after-tax account, like a Roth 401(k), as a retirement savings vehicle, you’ll pay taxes on the money now, but your withdrawals will be completely free of federal income tax. This is assuming you’re at least 59 ½ years old when you begin making withdrawals and you’ve had the account open for at least 5 years.

Educational Savings Accounts

If you have dependents, tax-deferred savings plans like 529 plans or Coverdell Education Savings Accounts (ESA) are a way to save money for their college education while lowering your taxes over the long term. Contributions to 529 and ESA plans are made with after-tax dollars, but withdrawals (including earnings from interest) are not subject to federal income tax—and in some cases, you won’t pay state income taxes on them, either.

Keep in mind that 529 and ESA funds must be used for qualified secondary education expenses, as outlined by your plan administrator. Otherwise you’ll be hit with extra taxes and penalties. You can, however, roll over funds from a 529 account into a Roth IRA account for the same beneficiary. This is helpful if you have funds leftover in the account when your student finishes college.

Capital Gains and Losses

Minimizing taxes isn’t the most important part of your investment strategy, but it should be part of your strategy. After all, it can have a big impact on your gains. Here are some terms you need to know.

  • Capital gains. Money earned by selling an investment for more than you paid for it.
  • Capital loss. Money lost by selling an investment for less than you paid for it.
  • Long-term capital gain or loss. Money earned or lost after owning an investment for more than a year. Long-term gains are taxed at a lower rate than ordinary income. The long-term rate is based on your adjusted gross income, or AGI, and could be anywhere from 0-20%. You could face additional surcharges based on your AGI.
  • Short-term capital gain or loss. Money earned or lost after owning an investment for less than a year. Short-term gains are taxed as ordinary income.
  • Offset losses or gains. Long-term capital losses can offset long-term capital gains, and short-term losses can offset short-term gains, dollar-for-dollar. Unused losses can also be carried forward from one tax year to the next. These losses have no time limit, so you can carry over losses until they are exhausted.

Minimizing taxes isn’t the most important part of your investment strategy, but it should be part of your strategy.

With this information in mind, it may make sense to hold on to some investments long enough that they can be taxed as long-term capital gains. Or, if you’re going to sell at a loss, doing so before the end of the tax year can offset other gains.

Avoid the Wash Sale Rule

Be careful when claiming investments as a loss. The IRS prohibits taxpayers from taking a loss on investments and then replacing them with the same or similar investment within the same 30-day period before or after a sale. This rule includes the day you sell your investment, so it actually ends up being 61 full days that you cannot buy an investment that is the same or similar, according to the IRS. If your transaction is deemed a wash sale, you won’t be able to claim any of the losses.

Health Care Costs

Set aside money for health care with pretax income using a flexible spending account (FSA), if your employer offers one. You cannot use the money to pay for premiums, but you can use it for copays, deductibles, prescription drugs, and even over-the-counter medications that qualify. You can contribute up to $3,200 in 2024 by payroll deduction into an FSA account, and potentially save hundreds of dollars in health care expenses.

FSAs come with one risk, though—if you don’t use the money during the calendar year, you may forfeit it. Employers can offer a two-and-a-half month grace period into the next year, so you can still spend the funds during that time. Or they may offer a rollover for up to $640 in unused FSA funds.

Charitable Donations

You can deduct gifts to qualified charitable, religious, or educational organizations in different ways. These gifts can be cash donations, stocks and securities, personal property and inventory, real estate, and more. If you want to make gifts to family members, like children and grandchildren, consult a professional about the best ways to make those gifts to minimize the tax impacts to you and them.

Photo Credit: Eric Fellegy