7 Tax Planning Tips to Consider
Hey, everybody, and welcome back to another episode of the Retirement Answers Show. My name is Jacob Duke. I'm a certified financial planner, and I help people just like you retire on a daily basis. In today's episode, I wanted to talk about seven different tax planning strategies that you can begin, deploying and using right now to help your taxes both this year, but also in the future as you think about retirement and perhaps the huge tax bill that kinda lays waiting for you there. So I'm really excited about this one because there's so many things that I run into as a retirement planner.
Jacob:Thinking about taxes and the negative effects of that that people I see that I work with all the time, I see in their portfolios, but also just the kind of the toll it takes on their spouses and their kids one day as money gets passed down to the next generations. So hopefully these different ideas and strategies are helpful for you as you think about ways to lower your taxes this year, but also as you think about the next ten to fifteen to twenty years as well. So let's go ahead and get started. And I wanna get started with, this idea of having improper investments, the wrong investments in your taxable or brokerage account. I see this all the time when people come into my office, they have all different accounts, their four zero one k's, their IRA's, Roth IRA's, and their brokerage account.
Jacob:And it's not uncommon for me to see that they have most of their conservative assets in their brokerage account. And this is not optimal for a couple different reasons. The first reason being is that anytime you have a fixed income like a bond or a CD or a money market or anything that's that's not a stock or a stock fund, anytime you have those types of assets that pay dividends or interest into your account and it's a nonqualified account, so it's a brokerage or a taxable investment account, whatever you prefer to call it, all of those gains or dividends or interest are gonna be taxed as a a nonqualified dividend or as a short term capital gain, which is just simply the normal income tax rate. So that is nonbeneficial because of the account type that a brokerage account is. It is not sheltered from taxes, meaning you will pay taxes on that every single year.
Jacob:So that's the first thing that I see is people are holding the wrong investments in their taxable investment account. Another big issue I see whenever people come into my office and I'm reviewing their portfolio, one of the biggest issues I see is that they're actively managed mutual funds in their brokerage accounts. So you might be wondering, you know, Jacob, why is this an issue? Well, I'm not gonna speak to necessarily active versus passive management or dig really into that or the pros and cons of one way or another. Just to keep it really simple and concise.
Jacob:An actively managed mutual fund is one that is being actively managed. It's just like it sounds, but, basically, the fund manager is trying to pick which stocks will do better. And so they're trying to buy those, and they're trying to sell the ones that are gonna do worse, but they're trying to figure that out. And so they're actively managing, you know, moving stocks in, moving stocks out, trying to figure out which things will be better or worse or do it at the right time. And so what that does is there's a lot of trading, a lot of buying and selling going on in that actively managed mutual fund, which in a taxable investment account is not beneficial because what that trading does is that creates more capital gains for you the investor that you will owe taxes on.
Jacob:So whenever we think about a mutual fund, there are three different reasons that you would owe taxes because of that mutual fund. The first is normal dividends. You know, whenever you invest in a stock or a bond fund, you will have dividends that come in from that particular investment. So that's something that you have no control over. Those stock funds will spit out dividends from the underlying holdings regardless of if you want them or not.
Jacob:They will do it if the holdings are, different stocks that have dividends to them. The second reason that you would pay taxes because of your mutual fund would be gains that are realized inside of the fund. And once again, this is something you have no control over. The fund manager remember back to our example of being an actively managed fund. The fund managers will be buying and selling, and they're creating gains whether you want them to or not, and you have no control over that.
Jacob:So it's really interesting. In 2022, perhaps your account value could go down as it did, but you could have a really high amount of capital gains in the account because the fund managers were buying and selling different holdings inside the account, which realized a gain for you. And so they pass that gain on to you, and you now have to pay that tax on that gain. So that's something that will probably leave a really bad taste in your mouth. Right?
Jacob:Because you lost money in your fund, but now you're paying even more taxes because of something you didn't control. And the third reason that you would perhaps pay taxes on mutual funds is something that you actually can control, and that is if you actually sell or buy the fund itself. So there are three different reasons that you would pay taxes on mutual funds. It would be dividends, which you don't have any control over. You would also have potentially capital gains that would come out of the mutual fund that you still don't have any control over because that would be because of the fund managers, not you.
Jacob:And then the third reason would be is if you sell your mutual fund after it's gone up in value, you would owe taxes on those gains. So that's the first thing is is if you have a taxable investment account or a brokerage account, it is not beneficial for you to have an actively managed fund in that account. If you're gonna use actively managed funds, which I'm not gonna get into whether you should or you shouldn't, If you do, you would wanna do that in your IRAs, your Roth IRAs, or your four zero one k because those are all tax sheltered accounts. The taxable investment account or the brokerage account, that is not tax sheltered, meaning you will pay taxes on any dividends, interest, or capital gains every single year. Another thing that you should probably be thinking about whenever you're investing in a taxable account is that ETFs, exchange traded funds, are going to be more tax efficient than mutual funds.
Jacob:And you're maybe wondering, Jacob, why is this the case? Well, it's something that's unique about an ETF versus a mutual fund. Mutual funds are required to spit out those dividends and interest and capital gains to you as the fund holder every single year. ETFs are able to, I guess, manufacture, for lack of a better word, and kinda combine those gains and losses in such a way that what they offset each other inside of the fund, which ultimately results in less capital gains being distributed out to you. So you heard that right.
Jacob:You could actually have, let's, for example, say, an S and P 500 mutual fund and then the S and P 500 ETF, and the ETF will generate less taxable income for you than the mutual fund simply because it's an ETF and not a mutual fund. So that's the next thing. I would probably say in a taxable account or brokerage account, use ETFs instead of mutual funds because they are more tax efficient. And in general, index funds, which are what we would call passively managed, they're just trying to match the index. They're not trying to be an actively managed fund.
Jacob:They're gonna be more tax efficient than those actively managed funds. So three rules of thumb, try not to buy and sell very much in your taxable account, use ETFs, and then use passively managed funds. That's the way that you can ultimately lower, the taxes you would pay any given year, on your taxable investment account. And just as a quick example of how I've actually helped someone lower their taxes in their taxable account is they came to me and they had a, a mutual fund that was basically spitting out between dividends and capital gains around $10,000 a year to them that was taxable income. And so now we've cut that down to 3,000 a year just of dividends or interest.
Jacob:And so there's a $7,000 difference every year at 20% that they're now saving on taxes that they otherwise would have to pay. So that's one simple way of because of the types of holdings, the way we're we're managing that account, we can lower their overall taxable income, and they can still achieve the growth in their account that they were wanting. So that's the first tip I have for you today on how you can plan out different tax strategies. The second idea I wanted to share with you is that doing Roth conversions when markets are down is very beneficial. The reason for that is is you can pay taxes on a lower amount of money to get money from your tax deferred account, like an IRA to a tax free account, like your Roth IRA.
Jacob:And you wouldn't pay as much tax on it, but you're still getting the same amount of shares over into your Roth IRA so that whenever the market recovers, now you're actually recovering in a tax free manner. So for example, let's say you originally in your IRA purchased an investment that was worth $10 per share, and then the market went down, so now it's worth $8 per share. And then you converted that one share at $8. You paid the tax on the $8 to get it over into your Roth, and then it grew at as the market recovered to $12 per share. So now by doing that, you've got $12 that's completely tax free in your Roth IRA as opposed to if you didn't do the conversion at all.
Jacob:Now you have $12 that's still taxable to you at some point in the future in your IRA. You would probably lean towards probably having that $12 in your Roth IRA, but the key is the $4 of growth. You get to pay the least amount of tax as possible by converting that one share that cost $8 per share over to your Roth, and now it's worth 12. So there's a $4 difference there that you basically get to have tax free as opposed to if you converted it at $10 a share and then it grew to 12, then you would only have a $2, tax free benefit per se. So converting while markets are down is the most beneficial way to do a raw conversion.
Jacob:So right now in 2023, we are actually down off of the all time highs back that we had in 2021, which now might be a good time to start thinking about doing raw conversions if you were planning on doing them at all in the future Because you could convert, like I said, at a lower price and pay taxes on a lower dollar amount even though you still own the same amount of shares so that whenever the market does recover and things go back up, you will have tax free growth in your Roth because that's where those shares are now. So that's strategy number two. Can you do Roth conversions while the markets are down? Because that's the most optimal way to do it if you are planning on doing Roth conversions. Okay.
Jacob:Strategy number three is something I see with a lot of my retired clients where they're not earning an income anymore because they're not working. But maybe they have social security or they have perhaps a pension or maybe they just have cash that they're living on. Right? But either way, it's a situation where they don't have any income or minimal income. It's a situation that I sometimes see where they have minimal income or $0 of taxable income, and they don't take advantage of that.
Jacob:So what do I mean by that? Well, if they have no dollars of taxable income, that means that they could take money from their IRA tax free up to a certain amount, before they actually start owing taxes on it and just take that out and live on that and put it into their cash account, go on a fund vacation, or they could convert that to their Roth if they want to tax free. So for example, I had a client that, could do this. They had no income or very minimal income, and they could take up to $12,000 out of their IRA tax free because their other sources of income were not high enough to push that 12,000 into some sort of 10% or 12% bracket. So they they actually took $12,000 completely tax free out of their IRA, and they just transferred it over into their checking account, and they went on an awesome vacation for for no taxes.
Jacob:Right? So they got the $12,000 tax free. You could also just do a Roth conversion. So if they didn't wanna go on the vacation, they could have done a conversion by saying, hey. We just wanna move 12,000 over into our Roth and basically do it for free.
Jacob:So the thought behind that is this is something that you need to be paying attention to every year, especially if you're retired and your income is is low compared to what you were making while you were working. If you're still working, this is obviously maybe not gonna be helpful for you because you can't do it. But when you do get to those retired years and your income is fairly low, you should evaluate that on annual basis or have your adviser evaluate that on an annual basis to make sure, hey. Are we using up all of the tax brackets efficiently as possible? Meaning, are we using up the 0%?
Jacob:So basically up to your standard deductions. And then are we using the 1012% efficiently so that we are paying as little tax both now, but also throughout the rest of our lives. So go back to our example where I had a client do this with $12,000. Man, if you could do $12,000, pull that out tax free out of your IRA, why wouldn't you do that? So it's a matter of not it's so this really is just a matter of paying attention to it.
Jacob:You know? What is your income every single year? Is it up? Is it down? And then planning for that on a basis.
Jacob:Alright. So tip number four that I have for you is is you should be utilizing the 529 account whenever you are either planning on paying, private school tuition or college tuition in the future or if you already are doing that right now. And many of you might be like, well, Jacob, I'm not really trying to do that. I'm not really trying to save for it. Don't really care to add more money to the college savings fund.
Jacob:But here's what I wanna tell you, is if you can add money to a 529 account for either your child or your grandchild and simply put the money in it and then take the money out the next day to pay their tuition, you can basically save taxes at the state level, assuming your state is one that does have a state income tax. You can save taxes on that up to a certain amount simply by putting the money into the $5.29 and then taking it back out the next day as opposed to paying it just cash out of your checking. So here's an example. So here in Arkansas, you can contribute as much as you want to a five twenty nine, but only up to 10,000 of that is deductible at the state level. And that's 10,000, that's for married filing jointly.
Jacob:It's 5,000 as a single person. So married filing jointly, you can deduct up to $10,000 of contributions to the five twenty nine off of your state income tax. So what that really comes out to be is around $500. So let's say that tuition for private school, sixth grade year for your son is, $10,000. Instead of just taking $10,000 out of your checking account and paying that tuition for the year, you should probably take the $10,000 contributed to the 529 account on behalf of your son and then immediately take that 10,000 out of the 529 to pay the tuition.
Jacob:And by doing so, you immediately just saved $500 just to do that simple two step process as opposed to just paying it out of cash. So that's one simple thing because as far as I know, there's no, time restraints or restrictions on how long that money has to be in the account. So, basically, it's a way to just put the money in and pull the money out, and you got a $500 deduction or 5% is around the state income tax here in Arkansas. Everybody's state is different. So, like, if you live in Florida or Texas, then you this doesn't help you at all because there's no state income tax to deduct against.
Jacob:Right? So this only works if you have a state income tax to deduct against. And then also, I'm not gonna get into five twenty nine rules for each state right now, but every single state has a different, deduction limit in terms of how much you can deduct off of your income. So some states, like in Arkansas, it's 10,000, but some states, it could be 16,000 or another state could be 8,000. So just look up your specific state's rules to know how much of your $5.29 contributions you can deduct.
Jacob:But either way, if you're paying for private school or if you're paying college tuition, you should absolutely if you don't have five twenty nine accounts already funded, you should be using them to funnel the money through and then immediately pay that tuition out of that five twenty nine so that you can basically get yourself an income tax deduction at the state level. Remember, this is only at the state level. It does not apply to federal taxes. I wish it did, but it just doesn't at this point. So that's kind of the fourth tip I have for you is utilize that $5.29 account for education expenses if you're paying those on an annual basis.
Jacob:Okay. Number five. We've got this one, and we've got two more. If you are charitably inclined, you should perhaps evaluate using a donor advised fund. Now what is a donor advised fund?
Jacob:Basically, it's just an account that you can add money to, and then you can have it invested, and then you can give it to the charity or church of your choice. So it's it's not like you're giving it right away to the church. You can contribute it to the donor advised fund and then invest it for, let's say, ten years, and then you can give it to the church. But what happens is whenever you contribute to a donor advised fund, you get the tax deduction in the year in which you contribute it, not the year in which you take the money out and give it to the church or charity. So here's a quick example or scenario of why you would think about maybe doing this.
Jacob:Let's say your normal income is a $100,000, but one year, for whatever reason, you earned $200,000 and you're single. And you're like, man, I'm not used to paying that high of a tax rate on that much more income, but every year I give, let's say, $10,000 to my church. So I normally make a 100,000 and I give 10,000. And this year I made 200,000. So one idea is if you're gonna continue giving 10,000 a year, based on your income, you what you can do is you can take a larger chunk of the total 200,000 that you made and front load that into a donor advised fund.
Jacob:So let's say that you take $40,000 out of your 200 doll thousand dollar income this year. You can dump that into your donor advised fund, and now you technically only earned $1.60. Okay? And then, also, you can take that $40,000 you contributed to your donor advised fund. You could take your 10,000 out that you normally would give to the church.
Jacob:You can distribute that out to the church. And then the 30,000 that's left over, that can be invested in such a way that it continues to grow for the church or charity that you wanna give it to in the future. But the key is the $40,000 that you put into the donor advised fund, that is gonna be a tax deduction immediately that year as opposed to if you didn't do the donor advised fund and you're giving 10,000 a year, well, you just give 10,000 a year for four more years, but it doesn't help you in this year when you earned higher than normal income. So that's that's one way that a donor advised fund perhaps could help you on your taxes this year is if you have a larger than normal income, perhaps you're in sales or something like that. And you're like, man, I made more money than I've ever made.
Jacob:I don't really feel like paying 30% taxes on it. Is there a way to offset this? There is if you're already giving or charitably inclined, you're like, man, I wanna front load that so that I can eliminate some taxes this year, but now I've got this fund built up to where I can donate to my church or charity out of it. So that's one way. Another way that you can utilize a donor advised fund is let's say you're doing a really big Roth conversion, and you're you're trying to lower the taxes on that Roth conversion, but you have a really big bucket of cash sitting at the bank.
Jacob:Let's say $200,000 and you're doing a $200,000 conversion. Well, the taxes on that $200,000 conversion are gonna be somewhere in the range of 40 to $50,000 depending on your tax brackets. So what if you said out of the 200,000 in cash that you have, you donated 50,000 to your donor advised fund, right, that you're already gonna give to the church in the future. But now you're doing that in an opportune way to say, hey, because I'm doing a conversion this year, I'm going to offset the taxes that I would owe on that conversion by doing a donor advised fund contribution this year as well, and it's a wash. So you accomplish two things.
Jacob:You have set up the account via the donor advised fund to donate to your church or charity throughout the next four to five years, but you also have limited your taxes this year on the conversion. So you got more money into your Roth that you otherwise wouldn't have. So the donor advised fund is a powerful way to, assuming your asset mix is right. Like you have to have enough cash to do a donor advised fund. But assuming that you do and you wanna do these other different tax strategies like a Roth conversion or perhaps you have a larger income year, you can offset those larger income years by doing the donor advised fund, which ultimately accomplish accomplishes two things.
Jacob:It lowers your taxes both now this year, but also, allows you to invest and provide a larger donation to your church or charity in the future. Okay. Number six, we're getting close to the end. Most of us have heard of RMDs, required minimum distributions. They begin at either '73 or '75 depending on the year in which you were born, which I've talked about before.
Jacob:But whenever those RMDs begin, that means you have to start taking money out of your tax deferred accounts like a four zero one k or a four zero three b or an IRA. Remember, Roth IRAs do not have RMDs. K? So whenever those RMDs start, let's say at age 73, and let's say you don't need all of that money and you're charitably inclined, What you could do is if your RMD was gonna be $50,000, but you only need 30,000 and you don't wanna just take the other 20 and have to pay tax on it because you don't need that money anyway, and you're already gonna give $20,000, let's say, to the church, well, you could do what's called a qualified charitable distribution, a QCD, on that $20,000 and send it directly from your IRA to the church. And you don't pay the taxes on that, and the church receives that, and they don't pay taxes on that.
Jacob:So the QCD is a way to offset your RMDs, and I do this with many of my clients where, let's say, they have a $20,000 RMD. They just want to give all of that to the church because they don't need the distribution. They don't need the income. They've got plenty other sources of income, And so they don't wanna pay the tax on it. And so they'd rather give more to the church as opposed to if they just took the RMD out $20,000 to their checking, boom, they get taxed, and then they give from cash to the church.
Jacob:That is a way less efficient way to do it because you got taxed as opposed to the QCD where you don't get taxed as the individual and neither does the church or charity. So the qualified charitable distribution is something that you should evaluate for your RMDs if you're over age 70, because that's something that you can use to offset the taxes on your RMDs if you don't need all of that money from your RMD. So qualified charitable distributions, check that out, think about that, and talk with your adviser on that if that's something that might be helpful for you if it might apply. Okay. The the seventh and final tax planning tip I have for you today is one that I could probably spend, a whole episode on, and in fact, I likely will, but it's something I call the widow's tax trap.
Jacob:And so, wow, that sounds kind of scary, but what is it? So as a married couple, let's say you got a million dollars in a tax deferred account, like an IRA, and we're gonna call this couple Bob and Sue. So let's say that Bob's got 500,000 and Sue's got 500,000 in each of their IRAs. While they're married filing jointly, their tax brackets are a lot wider and a lot higher than if they were single. Now once they reach RMD age, they can do some of the things that we've already talked about, like a QCD or something like that.
Jacob:But once they reach RMD age, they have to begin taking money out of their accounts. So on a million dollars of total tax deferred accounts, that can be upwards of $50,000 a year that they have to begin taking out of that account. Now let's say that Bob kicks the bucket, and then Sue is left with a million dollars, total for just her as a single person as opposed to them together married filing jointly. Now she still has to continue taking the RMDs, but now she's gotta take them and pay taxes on them as a single filer as opposed to a married filing jointly filer. And so this is something that everyone likely will encounter at some point.
Jacob:Rarely do couples pass away at the same time. Someone will survive the other person. And so they will be a single filer at some point in their life. And that is the widow's tax trap. You can have a million dollars in a tax deferred account, which as a married filing jointly, the taxes on that are gonna be a lot less because now you've got really wide tax brackets married filing jointly.
Jacob:But now Sue would have to begin taking those RMDs on a million dollars as a single person, which those tax brackets are cut in half, which she has no control over the fact that she still has to take the same amount because the RMDs are simply based on the amount that's in the account. So she would have to begin taking those distributions as a single filer, which ultimately caused her to pay not quite double, but almost double the taxes because now she's filing as a single person as opposed to married filing jointly. And this doesn't stop with just the taxes that she would pay. This also trickles down into Irma, which affects her Medicare premiums. Right?
Jacob:Because as a single person, her income adjustments for Medicare premiums are gonna be lowered as well. So if the RMDs kick her over the, single filers Irma brackets, then she would have an issue there. Another issue could be her Social Security taxation. If her RMDs are gonna kick her into a higher tax bracket, that means her Social Security could be taxed at a higher rate. So this is a huge tax issue for, married couples as they go throughout retirement because at some point, one of them will be a single filer.
Jacob:It's just a matter of when. So this goes back to the point of getting as much money from a tax deferred account like an IRA over into your Roth IRA while you can is very important for both now, but also for your surviving spouse in the future. And even then, I wouldn't stop there. I would say getting money into the Roths is super important for your spouse, but also for your children or whoever else inherits this money one day. Because yes, and a Roth IRA will have RMD requirements for whoever inherits the account one day.
Jacob:That's a non spouse like a child, but those RMDs are tax free. Right? Because it's coming from a Roth account. If all of that money is in a tax deferred account like an IRA, that money has to still be distributed, but it has to be distributed over a ten year period. Meaning if it's a million dollars, that's a $100,000 a year that has to be sent out to your child that now they have to pay income tax on, plus that's on top of whatever their other income is for the year.
Jacob:So that could be very suboptimal for your child in terms of how much money they would inherit or keep in the family one day, because there was no tax planning done on the front and to say, Hey, it might be more beneficial to pay the tax now and then let that money start growing so that in the future, whenever our kids receive that money, they will receive a tax free inheritance. So those are seven just really important tax planning considerations for you as an investor. If you're, you know, obviously getting close to retirement or already in retirement, and I hope that's, helpful for you. So thanks so much for tuning into this week's episode, and I look forward to speaking with you again next week.
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