5 Biggest Tax Planning Mistakes
And How You Can Avoid Them
Can you pay less tax?
As you file your tax return for 2022, the last thing you want to think about is next year’s tax return. However, it's never too early to start tax planning.
Even if you have a handle on your finances, there’s a good chance you don’t know about all your options to make sure you are making the wisest decisions regarding your tax planning.
We’re here to answer your tax planning questions. At Financial Strategies Inc. (FSI), we want to help you pay taxes strategically– so you are paying less, saving more, investing wisely, and giving to charities in mutually beneficial ways.
These are the 5 biggest tax planning mistakes to watch out for.
1. Not Utilizing Roth Accounts
The question a lot of clients have is, in what type of retirement accounts should I invest my money?
A tax-deferred account or a Roth account?
A contribution to a tax-deferred account (traditional 401K, 403b, IRA, SIMPLE IRA, SEP IRA, etc.) has an immediate tax benefit in the form of a current-year deduction, but you’ll have to pay taxes on the distributions come retirement.
While Roth contributions are nondeductible, meaning they do not include an upfront tax break, they do have substantial tax benefits in retirement– they can reduce the cumulative amount of taxes you pay throughout your lifetime. You pay taxes on the money you contribute, but after you reach age 59 ½ and the account has been open at least five years, the distributions are tax-free.
Roth accounts can also give more control of your tax liability in retirement. If you have a year where you need a larger distribution than normal, pulling it out of a tax-deferred account will raise your tax liability and may push you into a higher tax bracket. By having different account types to choose from, you have some control over the liability.
Additionally, any Roth money left at the end of your life is given to your heirs tax-free, which allows you to leave an effectively larger legacy to your heirs.
The sooner you begin to utilize Roth accounts the better because that allows more time for tax-free growth. Additionally, Roth IRAs offer some flexibility– you may be able to access some of the funds in certain situations before age 59 ½ without penalty, but the true value and benefit of Roth accounts are the tax-free withdrawals in retirement (post age 59 ½).
It’s all about finding the balance. Many clients invest in both traditional and Roth accounts. Work with a Fee-only advisor to find the balance that is right for you.
Related Article: Considering a Roth Conversion?
2. Ignoring Asset Location
Asset allocation is the breakdown of a client’s portfolio: how much money is in each asset class. Asset location is choosing which account type is ideal for each asset class based on tax ramifications.
Depending on gains or income produced by different asset classes, there are usually more tax efficient ways to structure a portfolio based on the tax structure of different accounts.
Work with your financial planner to create an asset location strategy most appropriate for you.
Over the long term, equities have tended to have a higher return than fixed income, so we like to keep more equities in the Roth accounts so you’re not paying taxes on those higher returns when they are withdrawn, assuming they are qualified distributions. Keeping your equities in tax-deferred accounts requires you to pay taxes on the distributions, which can turn long term capital gains into ordinary income for tax purposes.
It is important to understand how this strategy works, so you’re not surprised if the Roth accounts perform better due to the high-return equities they hold.
Here at FSI, we try to do most of the trades in accounts that are not taxable accounts to avoid realizing gains (unless there is loss or gain harvesting to be done– more on that in a bit). This is a more tax-efficient strategy than having the same allocation in each account and doing the same rebalancing in each account, but the effect on the portfolio as a whole stays the same.
3. Not Taking Advantage of HSAs
You may have heard of Health Savings Accounts (HSA), and you might even have one! But did you know you can leverage your HSA to pay less tax?
HSAs are tax-advantaged accounts specifically for people who have high-deductible health
insurance plans. HSAs allow people who meet the criteria to save money for medical
expenses that their insurance might not cover. The contributions, earnings, and distributions from these accounts are all tax-free, provided you use the distributions for qualified medical expenses.
The maximum contribution to an HSA for an individual in 2023 is $3,850. For a family, it's $7,750. Individuals who are age 55 and older (by the end of the tax year) can make catch-up contributions up to an additional $1,000. HSAs are advantageous because the money you contribute is entirely tax deductible up to the annual maximum contribution.
The funds in an HSA can also be invested and any of those earnings are tax-deferred, and tax-free upon withdrawal for qualified expenses. A common "mistake" people make with HSAs is contributing money and then using it without investing and giving it time to grow tax free. There are three benefits to Health Savings Accounts:
Tax deductible contributions
Tax-free qualified withdrawals.
If you use the funds right away or don’t invest them, you are only taking advantage of 2 of the 3 benefits. HSAs have the highest benefits because if used correctly, you will likely never pay tax on this money.
4. Ignoring Tax Loss and Gain Harvesting Opportunities
Market declines are not completely bad.
As surprising as that may sound, there is a silver lining to market declines. Tax loss harvesting is selling a security in a taxable account when it is down to take a loss on the income tax return to offset capital gains (or offset earned income up to $3,000 per year, if there are no capital gains).
If your loss exceeds $3,000 per year after offsetting capital gains, the IRS allows you to roll over the excess loss to the next year to offset any gains you have then. With tax loss harvesting, you sell at a loss for the tax benefit in the current year, and then buy back something similar (though not substantially identical) to continue to participate in the market as it hopefully recovers.
In taxable accounts, gains are taxed at more favorable long-term capital gains rates as long as funds have been held over 12 months. There are three brackets: 0%, 15%, and 20% (a 3.8% surtax may also apply). If the funds have been held for less than one year, the earnings are considered short-term capital gains and are taxed at ordinary income rates. We avoid realizing short-term gains as much as possible to keep your tax liability down.
While tax-loss harvesting is often discussed, tax-gain harvesting is less well-known.
Tax gain harvesting is intentionally realizing long-term capital gains. There could be several reasons to do this. One is when you are in the 0% capital gains tax bracket. This means the gains that are taxable do not increase the tax liability. By working with a financial planner who is taking your tax situation into account when developing a strategic withdrawal strategy, you may be able to reduce your tax liability.
Related article: The Silver Lining to Market Declines: Tax-Loss Harvesting.
5. Gifting to Charity in Tax-Inefficient Ways
One tax-inefficient way to give to charity is to withdraw the money from your IRA, then write a personal check to the charity. By withdrawing the money from your IRA, you are making it “income” that you then have to pay taxes on before you can gift it to the charity.
However, once you reach age 70 1/2, you can give via Qualified Charitable Distributions (QCDs). These are distributions from a tax-deferred account given directly to the charity and never taxed to you.
By using this method, you reduce your tax burden compared to distributing the funds and writing a check. It’s as if you’re taking a 100% above-the-line deduction!
Additionally, these distributions count toward your required minimum distribution (RMD) amounts. RMDs currently start at age 73 and you are required to withdraw a certain amount that will be taxed that year. By giving part of this distribution directly to a qualified charity, your tax liability is reduced (assuming you don’t need the full amount of the RMD to meet your income needs).
Also, if you want to leave a charitable legacy gift, it is a good idea to give from an IRA whenever possible (it is never ideal to leave Roth money to charity). This is again because the distributions will be taxable to the heirs but are tax-free to the charity. Work with a financial advisor and an estate planning attorney to develop a tax-efficient estate plan that meets your needs.
QCD’s are only an option after age 70 ½. Prior to that, we would consider donating appreciated shares to charity– giving a stock or fund that has unrealized gains from a taxable account to charity. The charity then sells the security and is tax-exempt.
This is an option if you have a taxable account and gains built up. If you are not retired and pulling from your accounts, it is important that you “pay yourself back”. Rather than giving cash to charity, you can give the appreciated shares, and then invest the cash you would have given to replenish your account and not affect your long-term success.
Related Article: Qualified Charitable Distributions
Talk to a Certified Financial PlannerTM Professional Today
Tax planning services are only one of the services we offer at FSI. We would love to work with you to create a financial plan that works for you. Whether or not the above strategies are in your best interest is dependent upon your individual situation. Additionally, never make a bad investment decision based on a good tax consequence. The above is for informational purposes only and is not to be taken as advice.
Talk to a Fee-only Certified Financial PlannerTM Professional
at Financial Strategies, Inc. to create a financial plan that is right for you.