A winter storm tore across the country this past week, but the vernal equinox is close at hand. That means crocuses and hyacinths should begin popping up soon, Easter Peeps and chocolate bunnies will begin lining store shelves (if they’re not there already), and baseball stats will begin crowding out basketball scores in the sports pages. The proximity to the spring season also means that tax day–April 15–will be here before you know it.
In anticipation of the upcoming tax-filing deadline, which is also your deadline for making IRA contributions, Morningstar.com will be featuring plenty of tips for managing your tax burden as part of our Tax Relief Week, starting Monday, Feb. 25. (Limiting your investment-related tax bills will be a particular focus.)
To kick things off, I asked Morningstar.com readers to share their best tax tips, and they were eager to comply, swapping tips on reducing taxes during retirement, managing tax-sheltered and taxable accounts, and good record-keeping. Poster ennnius wrote, “This is a great thread–I am learning much here.”
To read the complete conversation or share your own best tax tip, click here (http://socialize.morningstar.com/NewSocialize/forums/p/320977/3384789.aspx).
‘Essential to Our Long-Term Plans’
Several posters touted the virtues of tax-sheltered accounts.
BMWLover wrote, “For our retirement accounts I do my best to max out our contributions to our 401(k)s and Roths. The tax benefits of both are essential to our long term plans.”
Meanwhile, Dragonpat is partial to her traditional 401(k), with pretax dollar contributions. “Contribute the max to your 401(k),” she advised. “Until you max that out, I would not even bother with Roth contributions. It is the one big deduction I have that the alternative minimum tax allows me to have. The AMT has stripped me of my deductions for my children, state income tax (I live in a high tax state), and my property taxes.”
On the flip side, Retiredgary, like others who fret that taxes could go up, is a true believer in Roth vehicles, to which you make aftertax contributions in exchange for tax-free withdrawals in retirement. “Get everything into a Roth that you can,” this poster urged. “Things with regard to taxes are likely to get worse before they get better.”
Lengrav also likes Roths, but for a different reason. “While funding IRAs favor a Roth simply because you will probably save more! Most people that put $ 5,000 into a traditional IRA fail to save the tax savings this generates. But if you save $ 5,000 into a Roth you must pay the taxes currently. Therefore as time passes most people would see the same balance in either IRA. But those with a Roth have already paid the tax.”
For those inclined to convert traditional IRA balances to Roth, Dennis offered up the following nifty idea. “When you convert to a Roth IRA convert three to five times what you target as your conversion and put each multiple into a separate Roth account. When you file your income tax return in October under an extension, recharacterize back all but the best-performing Roth account. Two caveats: Make sure you are with an IRA sponsor that allows this. Recharacterize by mid-September. It can take the IRA sponsor a long time to process the recharacterization as this technique is popular.” (This article (http://news.morningstar.com/articlenet/article.aspx?id=540741) includes more details on recharacterizations.)
‘Tax-Efficient Funds That Can Be Held Forever’
Posters also shared tips for limiting Uncle Sam’s cut of taxable accounts.
The always sagacious Taylor Larimore advised, “In taxable accounts, except for short-term goals, hold only tax-efficient funds that can be held ‘forever.’”
Tax-managed funds fit the bill for Chief K, who urged, “For investments outside of IRAs/401(k)s, hold tax-managed funds that are near-clones of index funds (for example, Vanguard Tax-Managed Small Cap (VTSIX) or Vanguard Tax-Managed International (VTMNX)).”
Harvesting losses, which can be used to offset up to $ 3,000 in ordinary income or an unlimited amount of capital gains, is on Dragonpat’s to-do list each year. “I harvest capital losses against gains in my taxable account in an effort to minimize my tax bill,” this poster wrote.
Retiredgary noted that careful selling of long-term holdings can keep taxes down or limit them altogether. “If you are in the 15% bracket and in a state that does not tax capital gains,” he advised, “consider taking gains up to the top of that bracket each year as they will be taxed at a rate of 0%.”
Although most of the comments focused on limiting one’s federal tax burden, artsdoc noted that it’s worth plugging into state tax laws, too, especially if you live in a high-tax state. “One tax tip that I would give everyone living in a high personal income tax state is to familiarize yourself with state tax laws. I had always paid attention to federal tax laws and planned accordingly. Only within the past couple of years have I paid more attention to the California tax laws and it was pretty eye-opening. And now that our state personal income tax increased an amazing 30% for top earners, it does make an even bigger difference in tax planning. It truly does change your fixed income calculation comparisons (tax-equivalent yield becomes an even more important tool) and even those qualified dividends from (federally) tax-efficient mutual funds can become more expensive than you once thought.”
On the importance of tax management in taxable accounts, BMWLover was a rare contrarian, writing, “I don’t worry much about the tax consequences of my investment decisions in my taxable accounts. The way I look at it, if I have to pay more in taxes it just means that I’ve made more money. The only times I will look at tax consequences are when I am selling a stock and I’m just about to hit the demarcation point between short term gain and long term. The other is if I am deciding between two investments and one has qualifying dividends and the other does not.”
‘You Can Be Free of the Feds’
Posters also shared valuable advice about carefully managing income sources in an effort to limit their tax bills in retirement; that type of tax management simply isn’t available to those who are earning a paycheck.
Dennis’ post illustrates why tax diversification–a topic I discussed in this article (http://news.morningstar.com/articlenet/article.aspx?id=584823)–can be so valuable in retirement. “If you leave work well before 65, try to have significant retirement account balances and substantial taxable accounts. Living off the taxable accounts may result in low taxes if you have high basis in the securities. Create income to offset your deductions and to bring you up to your projected post 65 marginal tax rate by converting your retirement accounts to Roth accounts while you are in your first years of retirement living off the taxable accounts. Try to maximize your tax savings over your entire retirement period and not just for the current year. That maximization effort should take into account higher Medicare premiums based upon adjusted gross income and, if you are well off, Medicare taxes on your investment income.”
Frrries is also a believer in diversifying across multiple vehicles and carefully managing income sources on a year-by-year basis. “Set yourself up for an income tax free retirement,” this poster advised. “First, keep modified adjusted gross income below $ 25,000 and Social Security is tax free. Then build a taxable IRA account, a Roth IRA and a Health Savings Account. For example, a married couple might get about $ 30,000 in social security. Add $ 18,000 out of the taxable IRA, $ 18,000 out of the Roth and $ 12,000 out of the HSA. Total income is $ 78,000 per year 100% tax free in any state in the union (taking the standard deduction and two exemptions).”
Trial-running your planned income stream can help you manage your tax burden or even avoid taxes altogether, according to Darwinian. He walked readers through the process in this detailed post. “Take a blank 1040 form and work from the bottom up, on the second page. Enter any tax credits, and scan down your column in the tax table to find how much taxable income you can have that will be completely offset by this credit. Then, move up to the deductions and personal exemptions, and add these in. You will end up at the top of the page, with a zero-tax adjusted gross income. Next, turn back to the first page and fill in any taxable pensions and other income. If these are less than your zero-tax adjusted gross income, and if you have enough Roth/unsheltered assets to provide the remaining income you need, you can be free of the Feds, and will probably have only minimal state income tax. You only need to limit your IRA withdrawals for the coming year to the difference you just calculated. Be careful if you are taking Social Security income; the tax rate depends on how much other taxable income you decide to have, which makes it hard to figure. Do successive approximations on the SS worksheet, or call in a tax professional. And make sure you add any capital gains resulting from sales of assets for income.”
Chief K, meanwhile, noted that delaying Social Security has a tax silver lining, in addition to helping boost benefit size. “Deferring collecting Social Security means spending down ‘other cash’ instead of spending the benefits. In the meantime those benefits increase at 8% per year–without any taxes being due on the increase (plus inflation adjustments).”
TraderBob’s strategy won’t be for everyone, but could appeal to those with mobility in mind. “Buy an RV and set your residence in a state that does not tax Social Security or pension income and has otherwise low taxes (for example, South Dakota maybe).”
‘Behold With Amazement the Long List of Tax Benefits’
In addition to sharing tips for managing their income streams, posters also discussed how to make the most out of credits and deductions.
“Bunching” deductions–itemizing in some years and not others–has worked well for Texasboy, who wrote, “In entering retirement I had the pleasure of making my last mortgage payment. That basically left me with itemized deductions of property taxes and contributions. So we’ve begun alternating years of bunching the payments for two years allowing us to take the standard deduction the off year, thereby reducing taxable income for combined period. It may not be significant but [is] worth the effort, which is minimal.”
More deductions are available to small-business owners, noted Dennygal. “Start a small or very small business and put it in a limited liability corporation. Fill out your own Form 1065 and behold with amazement the long list of tax benefits available to small business owners–for example, deducting your Medicare insurance premiums as a business expense.”
Making charitable contributions carries multiple benefits in FidlStix’s book. “Channel as much into eligible nonprofits as you can afford,” he advised. “You’ll not only gain the satisfaction of helping out the causes you like, but you’ll enjoy a substantial tax deduction (assuming you’re not squirming under the alternative minimum tax burden).”
Dennis advised the following strategy for charitably minded seniors. “If you want to support charities while in retirement and have substantial taxable accounts, contribute as much as you can to a charitable gift fund before you retire, when your marginal tax rate may be at its highest. Then make your future gifts from the fund. This will keep your adjusted gross income under control and help avoid the higher Medicare premiums. The reduction of your income in retirement by pre-giving through the charitable gift fund and by converting to a Roth account may save your Social Security and Medicare if those benefits are ever means-tested.”
Posters also shared some intriguing outside-the-box ideas for limiting tax bills.
“Carry adequate insurance,” Chief K sensibly advised. “An accident or illness that requires you to raise large amounts of cash quickly can play havoc with any tax planning you’ve done.”
Meanwhile, Retiredgary urged other retirees to “go off the grid,” figuratively speaking. “Do things that increase your wealth but do not show up in the money economy such as growing a garden, painting your house yourself, working with friends to do repair and remodeling work on each other’s property, growing fruit trees, doing sewing or woodwork, and so on. The government has not yet figured out how to tax a freezer full of fruit and vegetables you grew or a deck chair you built. As a side benefit, many of these things are good hobbies and offer particularly retired people opportunities to get outside and stay physically active. It also makes a person fell a bit more competent and secure to have some of those basic skills.”
‘Don’t, I Repeat, Don’t Wait Until April to Start’
Posters differed in their attitudes toward doing their own returns or hiring a certified public accountant or other tax professional to handle their taxes.
In the “hire out” camp was EasyAsItGoes, who urged, “Hire a first-rate accountant to do your taxes. This is no time to go to the guy in the mall if your return is anything more than ‘simple.’ The really good CPAs know the tax code inside and out and they’ll play out a half dozen scenarios to find you the best return and give you advice about the coming year. See them midyear for a tune-up. My accountant says it every year, ‘Your job is to pay taxes . . . our job is to make sure you pay only what you should pay and not a penny more. ‘”
But Rule72 disagreed. “Learn how to do your own taxes!!! This is not rocket science,” this poster noted. “I agree it takes extra time and effort to do this yourself, but it really makes investing and estate-planning decisions a lot easier. You will know for yourself exactly the effects of various choices with traditional IRAs, Roth IRAs, 401(k)s, and so on. Each subsequent year gets easier.
Within the do-it-yourself contingent, posters shared valuable tips for getting it done.
Bnorthrop wrote, “My top tip for self-preparers is to use tax software. It allows one to run different scenarios to minimize tax obligation. I do this throughout the year, not just at tax time. Trying this with paper forms would be an insane amount of work. I’ve also used the software to do ‘what-ifs’ to calculate state taxes in those states I may wish to relocate to in the future. And for those who avoid direct ownership of MLPs due to their K-1 instead of 1099, tax software allows importing K-1 data. Even manually entering the data is basically a paint-by-numbers exercise.”
Others emphasized the importance of starting your tax preparation season early–ideally before the tax year is through. The benefit? Having time to actually affect your return.
MBAFBA wrote, “In early December calculate an estimate of year-end income and an estimate of next year’s taxes. Then review investments to see if there are capital losses to be captured, capital gains to be considered, and any other opportunities to reduce taxes. In some years, like 2012, this will put you in a knowledgeable position to take advantage of new opportunities like the (late) extension of the charitable IRA rollover.”
Rule72 was emphatic about not procrastinating. “Don’t, I repeat, don’t wait until April to start!” This poster went on to make working on taxes sound downright appealing. “Start in January. Get a favorite beverage, some soothing music and spend two to three hours about once a week. You’ll be less stressed, smarter and richer for it. [I spent] my time during [last week's] snowstorm with a glass of wine, jazz, and double-checking my tax forms that I completed a week ago. Bottom line–put yourself in a position to take advantage of opportunities before it is too late.”
Several posters noted that, whether you’re doing your taxes yourself or outsourcing to an accountant, keeping good records is essential to a smooth tax season.
EasyAsItGoes wrote, “Your accountant (or tax software) is only as good as the information you give him/her/it. Start the year by keeping good records.”
Good record-keeping is also a must for Rule72, who shared, “The most difficult part of doing your taxes is finding and sorting all the necessary documents. Do this year-round; simply throw receipts into a folder or box as you get them.”
See More Articles by Christine Benz
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