Tax returns are a pain point for most of us. The process of gathering the needed documentation, handing the data to your accountant, or inputting the data into a program yourself, culminating with the common result of “you owe money” is unpleasant for all of us. From our perspective, a further negative is that all tax returns are backwards looking. They are looking at data from a prior year and nothing we can do in the current year can improve upon last year’s results.
However, tax returns can be an opportunity to improve your tax situation going forward when the correct analysis is applied to your most recent tax return. Every line item in your return tells a story:
- What marginal tax rate does your income fall in?
- Are you charitably inclined?
- Did you have an unusual taxable event?
- Are you old enough to take IRA distributions, but young enough that you do not have to take them?
How can tax planning be used to improve your tax situation going forward? Here are a few examples of ways that we have used tax planning with clients:
Concentrated stock positions
An investment is considered “concentrated” when that holding comprises more than 5% of a person’s wealth. At times, though, the decision to sell some or all of that investment is difficult because there are such large capital gains: the investment has grown to a value much higher than when it was purchased. That large gain will trigger a tax liability. The data from last year’s tax return can be used as a baseline to calculate how much of capital gain can be taken in the current year and not make the following year’s tax return come with an unexpected liability. What also must be taken into account is that most people fall within the 15% Capital Gains rate, and we want to be careful not to trip them into the 20% Capital Gains Rate.
Zero Percent Capital Gains Rate
Along those same lines, there is a 0% Capital Gains Tax Rate if your income is below $53,600. There can be a golden opportunity to sell a highly appreciated investment if one has retired early and is not yet taking retirement income above $53,600, including Social Security, and pay zero tax on the sale. Dividend income and other investment capital gains need to be considered when calculating how much of a capital gain you can incur and stay within the 0% tax bracket.
Roth IRA Conversions
Roth conversions often make sense, but not always. When we look at long range planning, we can tell if converting some of an IRA to a Roth in the current year, and possibly again for several years going forward, will keep someone in their current tax bracket and prevent them from shifting into a higher tax bracket over their lifetime. We can also see the impact on how much a Roth conversion will increase their current tax year liability.
Tax planning can also help us to quickly determine if you are eligible to make retirement plan contributions, including Roth IRAs. We can also see the rates you are paying in Medicare premiums and if you incur any additional income in the current year if your premiums will increase in subsequent year. Other nuances are also visible in the planning such as when the 3.8% Net Investment Income Tax will be added to your tax return. So many people want to separate taxes from their financial planning as it seems like taxes are just something we must deal with but cannot really do anything about. As you can see, that is not always the case!