Yes, we know it’s only December, but it’s never too early to start planning for tax season. It’s also good to keep in mind that tax concerns involve more than filing your annual tax return before the April deadline! In this special section, you’ll find stories on How to Plan Ahead for Taxes in Retirement, Estate Tax and Lifetime Gifting, and a basic piece on Understanding your Tax Return.
Diversification isn’t only for your investment portfolio. If you’re actively saving for retirement, it’s also a good idea to diversify how and when your savings will be taxed so you can successfully navigate two unknowns in retirement:
How much of your income will be taxable?
Income includes not only your retirement savings, but also Social Security, pensions, nonretirement investments, and other potential sources of income. What will your tax rate be after you retire? Recently, rates have been relatively low by historical standards. It’s conceivable they could rise before or during your retirement years.
Despite these unknowns, it’s still possible to plan for a potentially better tax outcome. The trick is to use accounts with a variety of tax treatments to better control your taxable income in retirement. Generally, there are four types of accounts available in retirement, each with their own tax advantages:
Contributions to these accounts—which include 401(k)s, 403(b)s, and traditional IRAs—generally reduce your taxable income dollar for dollar in the year you make the contribution. Pretax contributions and gains aren’t usually taxed until retirement, at which point withdrawals are subject to ordinary income tax rates. But there are some rules. Starting at age 72, the IRS requires you to take minimum distributions (RMDs) from your tax-deferred savings accounts each year.
Unlike tax-deferred accounts, contributions to Roth 401(k)s and IRAs are made with after-tax dollars, so they won’t reduce your current taxable income. But when you withdraw the money in retirement, you won’t owe taxes on appreciation, income, or withdrawals. A Roth IRA is exempt from RMDs, while a Roth 401(k) is not—though you can still avoid RMDs by rolling it into a Roth IRA when you retire.
These traditional bank and brokerage accounts are also funded with after-tax dollars. For brokerage accounts, you can sell securities and contribute or withdraw money at any time and for any reason without penalty. Any taxable investment income is taxed in the year it’s earned, and investments sold for a profit are subject to capital gains taxes. If you sell an investment for a loss, you may be able to use it to offset any gains—and/or up to $3,000 of ordinary income. These accounts are also exempt from RMDs.
Although not traditionally considered retirement accounts, health savings accounts (HSAs) can be an effective savings vehicle (if your employer offers one and you’re covered by an eligible high-deductible health plan). Contributions reduce your taxable income up to annual limits, investments grow tax-free, and you pay no tax on withdrawals for qualified medical expenses. Once you reach age 65, withdrawals for nonmedical purposes will be taxed as ordinary income. HSAs are also exempt from RMDs.
Tax diversification in action
The right mix of retirement accounts for you depends on several factors – your current marginal tax rate, your tax rate in retirement, and how much flexibility you’d like when making withdrawals in retirement. Nevertheless, there are some basic guidelines you can consider when deciding which retirement accounts to fund first:
Capture your match:
If your employer offers matching contributions to your retirement account, your first priority should be to save enough to get the full match. Never say no to free money.
Consider an HSA:
As you age, you’ll likely have more health expenses. If you can pay them with tax-free dollars, do so. Employers sometimes provide matching contributions, though they’ll count against the annual limits.
Maximize your tax-advantaged savings:
Consider an appropriate combination of tax-deferred and Roth accounts, depending in large part on your current tax bracket:
If you’re in a lower tax bracket (0%, 10%, or 12%), consider maxing out your Roth accounts. Potentially, your tax bracket in retirement will be equal to or higher than it is today, especially given today’s lower tax rates. Also, early in your career, you may be in a lower tax bracket than later in life.
If you’re in a middle tax bracket (22% or 24%), consider splitting your retirement savings between tax-deferred and Roth accounts. While it can be difficult to predict your future tax rate, if you contribute to both types of tax-advantaged accounts you may alleviate some of that uncertainty. If the majority of your workplace savings are in a traditional 401(k), for example, you might opt to diversify with a Roth 401(k), if your employer offers one.
If you’re in a higher tax bracket (32%, 35%, or 37%), there’s a good possibility your tax rate in retirement will be the same as or lower than it is today, so maximizing your tax-deferred accounts might make the most sense.
in a brokerage account:
If you still have more left to save after you’ve taken the steps above, consider investing in a traditional brokerage account. Income generated in these accounts is generally taxable, but there are strategies you can employ to improve their tax efficiency:
Hold appreciated investments for more than a year so you can take advantage of long-term capital gains rates, which range from 0% to 20%, depending on your income.
Consider tax-efficient investments, such as exchange-traded funds, index mutual funds and tax-managed funds, which by and large don’t create as many taxable distributions as actively managed funds.
Opt for tax-advantaged municipal bonds, especially if you’re in a high tax bracket. The interest paid on such bonds is typically free from federal taxes and, if issued in your home state, is generally free from state and local taxes, as well.
Consider a Roth conversion:
If your income precludes you from contributing to a Roth IRA, one potential option is a Roth conversion. With this strategy, you convert all or a portion of funds from a traditional IRA to a Roth IRA and pay ordinary income taxes on the converted amount in the year of the conversion. Despite the additional taxes, a Roth conversion can help diversify a mostly tax-deferred portfolio. Logistics can be tricky, so consult a tax advisor to help you make decisions.
Predicting future tax rates is a bit of a guessing game, but with variety of account types available, there’s potential to create flexibility and a comfortable level of control over future tax bills.
When you give assets to someone—whether cash, stocks or a car—the government may want to know about it and may even want to collect some taxes. Fortunately, a large portion of your gifts or estate is excluded from taxation, and there are numerous ways to give assets tax free, including these:
Using the annual gift tax exclusion
Currently, you can give any number of people up to $15,000 each in a single year without incurring a taxable gift ($30,000 for spouses “splitting” gifts). The recipient typically owes no taxes and doesn’t have to report the gift unless it comes from a foreign source.
However, if your gift exceeds $15,000 to any person during the year, you have to report it on a gift tax return (IRS Form 709). Spouses splitting gifts must always file Form 709, even when no taxable gift is incurred. Once you give more than the annual gift tax exclusion, you begin to eat into your lifetime gift and estate tax exemption.
Using the lifetime gift and estate tax exemption
With the passage of the Tax Cuts and Jobs Act (TCJA), the gift and estate tax exemption has increased significantly. Prior to 2018, the gift and estate tax exemption was $5.49 million. Through 2025, the exemption is $11.7 million (adjusted annually for inflation). The $11.7 million exemption applies to gifts and estate taxes combined—whatever exemption you use for gifting will reduce the amount you can use for the estate tax. The IRS refers to this as a “unified credit.” Each donor (the person making the gift) has a separate lifetime exemption that can be used before any out-of-pocket gift tax is due. In addition, a couple can combine their exemptions to get a total exemption of $23.4 million.
There’s one big caveat to be aware of—the $11.7 million exception is temporary and only applies to tax years up to 2025. Unless Congress makes these changes permanent, after 2025 the exemption will revert to the $5.49 million exemption (adjusted for inflation). So here is the big question—if this new exemption disappears after 2025, how do you take advantage of it before then?
Lock in the new exemption
For the majority of people, the gift and estate tax exemption will allow for the tax-free transfer of wealth from one generation to the next. For those who have acquired enough wealth to surpass the gift and estate tax exemption, there are several strategies that could lock in the $11.7 million exemption.
The simplest way is to gift your assets to your loved ones now, rather than waiting until you pass away. If you have the means, giving the assets now has two advantages. First, you get to see your loved ones benefit from your gifts. Second, the gifted assets could increase in value for your loved ones—and could decrease your taxable estate.
For example, if you were able to give the entire $11.7 million to your children today, that money could grow over time. At a growth rate of 5% per year for 10 years, that $11.7 million gift could end up being worth over $19.05 million, and your loved ones will have received the entire amount free from gift or estate taxes.
On the other hand, if you held onto those assets and you passed away in 10 years, a large portion of the $19.05 million would be taxed at 40%. Additionally, in 10 years the gift and estate tax exemption will have likely reverted back to the lower $5.49 million amount (for dates after 2025). That could result in your estate having to pay over $4.74 million in federal taxes, leaving your heirs with about $14.33 million in assets rather than $19.05 million if you made the gift sooner.
Ensure your gifts are used and managed properly
One concern many people have when it comes to giving assets away early is that sometimes the person receiving the gift may not be ready to handle the responsibility of managing such a large amount of money. A good example of this is a large amount of money gifted to a young child or teenager. One way to give those assets, but ensure they are protected from misuse, would be to create an irrevocable trust and make the child or teenager the beneficiary.
This allows you to set the rules of the trust and determine how the assets will be invested and distributed. For instance, you could create a trust that stipulates the beneficiary can only have access to the income generated by the assets—or you could set specific rules, such as the beneficiary must graduate from college before having access to the funds in the trust.
There are numerous options when it comes to structuring a trust, and each state has its own rules. Meet with an attorney or tax professional to learn more.
Other ways to give tax-free
You can make unlimited payments directly to medical providers or educational institutions on behalf of others for qualified expenses without incurring a taxable gift or affecting your $15,000 gift exclusion. This is a great way to help a loved one with large medical bills from an illness or to help pay for a family member’s education. For example, if you want to pay your granddaughter’s $50,000 tuition for her medical degree, you could pay the university directly for her tuition and still give her an additional $15,000 tax-free. This reduces your taxable estate and helps preserve your lifetime exemption.
How to minimize taxes for recipients
One thing to remember about the assets you gift is that your cost basis will transfer over to the recipient. So, if that asset has appreciated in value significantly prior to the gift, the recipient could incur the substantial taxable gain when selling that asset. Highly appreciated assets that are received as part of an estate, on the other hand, generally get a “step up” in basis, which means a taxable gain could be avoided if the asset is sold soon after being received.
Carefully select what assets you gift to minimize the impact of taxes. In general, cash and assets with little appreciation are better for gifts while highly appreciated assets are better to transfer as part of your estate.
Keep in mind:
Lifetime gifting can be a great strategy, providing you leave yourself enough to live on. For the gift to count, it must be a complete and irrevocable transfer. This article focuses only on the federal tax implications for gifting and estates. Depending on where you live, there could be state tax consequences for your gifts and estate.
Take the time to meet with a tax and estate planning professional to ensure your gift and estate plans are well thought out and properly implemented. As with any tax planning strategy, there is always the possibility that Congress could change the laws related to the gift and estate tax exemption. You’ll want to review your gift and estate strategy each year to be sure that your plans are still relevant based on your financial situation or changes in tax laws.
Tax season is right around the corner, so it’s not too early to start thinking about preparations. Do you anticipate a refund? Or do you owe the government money each year? Many people find themselves surprised when their tax refund is smaller than previous years, or worse—that they need to cut a check to Uncle Sam.
What’s really going on with your taxes? Consider the following:
Tax refunds (or bills) depend on paycheck withholding
Each paycheck has a portion of your earnings taken out and sent to the IRS—a process known as tax withholding. In a perfect world, your total taxes withheld for the year would equal the total tax bill reported on your personal tax return. If that were the case, you wouldn’t get a refund, nor would you owe any tax when you file your return.
Unfortunately, changes in income or deductions can make estimating your tax bill difficult. That’s why most people either receive a refund or need to pay a bit extra when they file their tax returns.
Don’t get too excited about getting a refund (or feel bad if you need to pay)
The truth is, both options are neither good nor bad. A refund just means that you over-withheld taxes from your paycheck, and paying additional taxes means you under-withheld from your paycheck. As exciting as a refund might be, it’s really just the federal government returning the money you overpaid. Think of it as giving the government an interest-free loan: The government gets to use your money, and then they return it to you without any compensation—not a great investment.
Tax experts generally recommend trying to withhold just enough to cover your tax bill or even pay a little bit extra when you file your return. That way you have more money in your pocket throughout the year potentially earning some additional income. Ultimately, it’s your total tax bill that matters, not whether you owe or get a refund. The following information will help you determine your tax liability—and whether you’ll get a refund or owe a bit more on Tax Day:
The total tax due: what you actually owe in taxes for the year
Income tax withheld: total amount of taxes taken out of your income that year
The refund you’ll receive: the amount you “overpaid” (i.e., the amount you over-withheld that year); or the amount you owe: what you under-withheld in taxes for the year
The amount withheld from your paycheck is the key to understanding why your refund may be lower or why additional taxes may be due. To know if you get a refund or owe additional taxes, simply compare your total tax to the total amount of tax withheld.
If the amount withheld is larger, you overpaid and will be eligible for a refund. If the total tax is larger, you under-withheld, so you will have an amount you owe and will have to cut a check for the difference.
In 2018, the IRS changed the withholding tables in an attempt to account for the lower taxes that many people would pay under the Tax Cuts and Jobs Act (TCJA) of 2017. These tables are used by employers to determine how much should be withheld from your paycheck.
The withholding tables reduced the amount withheld from each paycheck so that on Tax Day, the IRS wouldn’t have to issue an enormous number of refunds.
Unfortunately, changing the withholding tables is not an exact science. The unintended consequence of those changes resulted in some people withholding less than expected, which caused their refunds to be lower or in some situations caused them to owe on Tax Day.
How to prepare for next year
If you want a larger refund next year (not recommended, from a financial perspective), you can update your Form W-4 to change how much is withheld from your paychecks. Check how much is being withheld from your paycheck at least once or twice a year to stay on track to a targeted withholding amount and to ensure you don’t end up under-withholding too much (which could result in penalties). For help determining the amount that should be withheld, use the IRS’s calculator or meet with a tax professional.