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Some people find themselves saying this statement this time of year. For some they say it year after year after year. And for others its even worse. Do you find yourself saying “Is there anything I can do?” Or “Why do I have to pay so much, I make less than most people I know?”
Well don’t fret there is relief. In case you weren’t aware, there are two tax systems in this country. They are — those that are informed, and those that are uninformed (just kidding).
Let me explain, you can take two people making the same income, having the same personal situation, as well as the same personal tax deductions, but the one who has financial and tax guidance from a professional will pay less in taxes than the other who does not.
Now you are probably asking, “So how does this help me save on taxes?” Well of course everyone’s specific situation is different and one strategy that works for one person may not work for others, but let’s take a look at some simple ideas. I will not waste your time covering personal deductions like home, medical and the usual household deductions.
Retirement plans
First we must look at the obvious, retirement plans. Contributing to a qualified retirement plan can do several things for you. It reduces your taxable income, which in turn reduces your out flow to other tax items like state taxes, SSDI and Medicaid. In addition usually when participating in a qualified plan there is a match involved, whether or not you are self employed, there should be a company match. This gives you an instant positive return. Not to be left out is the power of tax deferral. There has been study after study done, and the power of tax deferral has always prevailed. Reason being, if you do proper financial planning, by the time you access these funds you should be in a lower tax bracket, but I do stress this will usually happen only with proper financial planning. If your company or employer does not have a qualified plan in place, there are a multitude of options available that will still give you a nice tax deduction.
Tax credits
Next, let’s look at tax credit programs. Yes, there are such things as tax credits. You might be wondering, “What is the difference between a tax deduction and a tax credit?” For example if you look at $100 in taxes, a tax deduction will result in a $20- $35 reduction of that original $100 in taxes. However a tax credit is $100 in reduction of the $100 paid in taxes.
The government has made certain provisions in the tax code for a tax credit in certain investments. I know, I know, but you have never heard of this strategy before. My only answer is that unless you work with someone who is educated and experienced in full financial planning, you will never see this kind of planning.
Managed accounts
Another strategy that is overlooked, due to lack of knowledge by most advisors, is managed accounts. In very simplistic terms these are investment and retirement accounts that are managed professionally to maximize returns and tax efficiency with unlimited investment flexibility.
When discussing managed money context, tax efficiency is a year-round strategy. One reason is that there are now many more ways to incorporate tax-aware elements into an investing strategy. A decade ago, tax-efficient money management was straightforward. If you held equity investments for a year and a day, the return on those investments, when realized, was a long-term capital gain. The longterm capital gains tax was 20 percent. For clients in the top tax bracket, this meant an almost 50 percent reduction in tax owed. Money managers who included a commitment to hold their clients’ stocks until they qualified for the long-term capital gains tax rate in their investment process could claim to be tax-aware. That approach is still valid (thanks to recent tax legislation that cut the long-term rate even more so), but time and evolving technology have made it seem overly simplistic. It now represents only one possible first step, not the last word, in the tax-aware money management process.
One strategy used in this type of asset management is “tax loss harvesting.” A more sophisticated tax-management technique emerged during the late 1990s. How it works is when a manager sells a security at a loss, that loss is applied against a gain. For example, if Stock A declines below its purchase price, but the manager still believes in the stock, he or she may sell it at a loss, perhaps buying a similar stock or an exchange-traded fund to retain sector exposure. Thirty-one days later, when the wash sale rule has been satisfied, the manager buys the stock again. The realized loss is then banked against a variety of uses when tax time rolls around. The manager can offer the loss to the client as an offset against a gain outside the portfolio. Say the client has sold real estate into a rising market, realizing a $100,000 capital gain. You can use the loss in the managed account to offset the gain. Alternatively, if there are securities in the managed portfolio that have appreciated to the point where they are over weighted in the account, the manager can sell the securities to rebalance and realize the gain, then offset it with the loss harvested earlier. These strategies can limit the tax bite and sometimes simultaneously promote growth in the managed accounts. Another strategy which even more tax beneficial, but too complex to cover in this short article, is “Tax-Lot Optimization.”
Real estate capital gains
Since I brought up capital gains in a real-estate sale, let’s strategize a little further. Some people have rental homes or a vacation home, or even just extra real-estate that they would like to sell. However they feel that because of the capital gains the cost is too high and they are better off keeping the property. With the proper planning you may sell that real-estate and pay no capital gains as well as receive a nice annual or monthly income from the proceeds. This will still reduce your taxes and reduce the stress that the extra property was putting on you as well as increase your income and retirement assets.
Seek qualified help
In conclusion, if you find yourself in a tax pinch every year, don’t wait, please seek a qualified financial professional who can help alleviate the stress of tax season and set up tax planning strategy that will fit your dreams.
Jason M. Duhon, MBA, Regional Vice President
