Tips to Prevent Overpaying the IRS. Why it's Important to Have a Tax Plan
This article was published in the March 2023 issue of the Traverse City Business News and can be read in its entirety below. Black Walnut Wealth Management contributes articles and is featured in various media outlets.
Most of us only deal with taxes during tax season, and then we ignore them the rest of the year. However, one of the best ways to retain more of your wealth is to reduce the burden of taxation. An ongoing tax strategy can reduce your tax bill and keep the IRS away from as much of your money as possible.
Tax law is like a game: If you understand the rules, you will have a greater chance of coming out ahead or, in this instance, reducing your tax bill and paying less. Here are some tips on how to make that happen:
Build a Tax-Efficient Retirement Plan
Retirement planning will often be a key point of conversation when working with your financial advisor. By stress-testing your plan, you can quickly see if your current retirement accounts, savings rates, and other assets will be adequate for your desired retirement lifestyle.
A direct way to reduce your tax bill is to contribute money into tax-deferred savings accounts, such as a 401(k) or IRA. But, to maximize your savings, you will need to determine your current cash flow needs and your ideal retirement income. A proper financial plan will look at both factors and choose the best way to use your tax-deferred savings accounts to save you money both now and in the future.
For example, a $50,000 withdrawal from a Roth IRA will have a wildly different tax impact than that same distribution from a traditional IRA. Creating a tax plan can help you strategically withdraw from your various retirement accounts and reduce your tax liability.
Contribute to Your Health Savings Account
Health savings accounts (HSAs) offer triple the tax savings. This may sound too good to be true, but HSAs have no federal income tax, no state or local taxes, and no Federal Insurance Contribution Act (FICA) taxes. If you are eligible for an HSA, your money will be tax-deferred and can be withdrawn tax-free to pay for medical expenses.
Because HSA account balances roll over from year to year, you can build up quite a nest egg to cover current or future medical expenses in retirement by contributing to the limit each year. Think of it as a Roth IRA for medical expenses.
As of this year, HSA owners now have higher contribution limits to help them do just that. If you have individual coverage, you can contribute $3,850; for family coverage, the limit is $7,750. There is also an extra catch-up contribution of $1,000 available for those aged 55 and older. If you can’t max out the yearly limit, attempt to contribute enough to cover your deductible and take advantage of your employer match, if available.
Use a Roth IRA to Transfer Wealth
Roth IRAs are an attractive savings vehicle for many reasons, including no required minimum distributions (RMDs), tax-free withdrawals after age 59½, and the ability to pass wealth tax-free to your heirs. Although Roth IRAs don’t have RMDs, other accounts like a traditional IRA might. This will force you to increase your income and could bump you up to a higher Medicare range, which can add $100 to $150 in monthly premiums.
You probably know the effects taxation can have on your assets and the inheritance you hope to pass on to future generations. For example, if you passed down a traditional IRA, non-spouse beneficiaries used to be able to stretch the distributions from that account over the beneficiary’s life. Now they must liquidate the account within ten years of inheriting it (with some exceptions), thanks to the SECURE Act. This significantly decreases the account's value due to the amount of taxes paid in a short time. But, if you pass down a Roth IRA instead, there is no income tax due on the distributions as long as the account is held for more than five years and the account holder is 59½ or older.
If you have traditional IRAs already or earn too much to qualify for a Roth IRA, consider a Roth conversion to remedy the tax loss. The basic process to convert your IRA is to withdraw the amount you’d like to invest in a Roth, pay the tax owed on the distribution, then reinvest it into a Roth account. Be sure to work with a professional to determine the best time to do this, so you don’t push yourself into a higher tax bracket or are forced to use funds from the account to pay the extra taxes on the distribution. Also, stay on top of potential tax changes that could limit the availability of this option for you.
Deduct Eligible Charitable Contributions
Annual gifts to qualified charitable organizations may be deemed an eligible itemized deduction. Under the Tax Cuts and Jobs Act, fewer taxpayers itemize deductions due to the doubling of the standard deduction. Regardless, charitable giving is still a useful tax-minimization strategy.
To benefit from charitable giving, you’ll have to plan. With the new higher standard deduction, you’ll need to make sure your total deductions for the year, giving included, exceed $13,850 for an individual filer and $27,700 for those married filing jointly. If your deductions fall below this amount, consider bunching your giving or doing several years’ worth of giving in one year.
You may also want to look into using a donor-advised fund to combine all charitable contributions in a year and then distribute the funds to various charities over several years. With this strategy, you may be able to itemize deductions in one year and take the standard deduction in the following years to achieve a tax benefit that you may not have otherwise.
Review Your Previous Tax Returns
You can learn a lot from the past. Look at your previous tax returns with a professional to search for deductions or credits you may have missed, opportunities to lower taxable income, and plan for the next tax season. Take these factors into consideration when making a tax plan:
- Review notable tax law changes for 2023 (such as Secure Act 2.0) that may affect you.
- Review your capital gains and losses
- Review your retirement savings options
- Consider Roth IRA conversions
- Consider additional year-end tax strategies
- Understand potential tax law proposals
Get Ahead with Tax Planning
Tax planning can save you money today and in the future. But the key is partnering with an experienced Certified Financial Planning® professional who can help you understand how each possible opportunity works and how it fits into your strategy and long-term goals.
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