Fourteen Tax Management Techniques

The following is a guest post from Marotta Wealth Management.

No one approaches financial planning with the goal of paying more taxes. Tax management, like all financial planning, is based on the premise that small changes made over time can achieve big goals. Good investment returns are important. But over the next few years, comprehensive tax management may reap even greater gains.

Don't file your taxes in April and then forget about them for the next 10 months. By investing a little time throughout the year, you can create compounded value. The 14 techniques described here may help you lighten your tax burden.

1. Check line 45 on your 2008 IRS form 1040 to see if you paid any alternative minimum tax (AMT) last year. People subject to AMT pay an average of $6,000 more than they would otherwise. AMT turns tax planning upside down. Because conventional wisdom may not apply, be sure to review your financial affairs with a professional.

2. This year offered a spectacular opportunity for realizing capital losses. Realized losses can offset realized gains. They can also be deducted against ordinary income up to $3,000 a year. Any excess above $3,000 is carried forward and can be deducted in future years.

3. You can realize capital losses and still stay fully invested. Sell the security, and then wait 31 days before buying it back. Alternately, double up. Purchase the same number of shares you currently hold. Wait 31 days. Then sell the original shares for a tax loss. Waiting a month between the sale and the buyback avoids a so-called wash sale, which would prevent you from taking the tax loss.

4. Individual stocks offer more opportunities to realize capital losses or gift capital gains. This is useful primarily in larger portfolios. A portfolio of individual stocks collectively may mimic the return of an exchange-traded fund and still provide additional tax savings. For example, although the total return might be 10% for the year, one of the individual stocks has doubled and two others lost 50% of their value. By holding individual stocks instead of the fund, you are able to sell the two stocks that have a 50% negative return and take the loss on your taxes. Holding the stock that has doubled in value postpones paying capital gains.

5. Using appreciated stock for charitable giving can avoid paying capital gains entirely. This allows you to contribute up to 15% more than you could with a cash gift.

6. This year also extended the opportunity to make qualified charitable distributions. If you are 70 1/2 or older, gifts you make directly to charity from your IRA are not counted as income. In this way you can reduce your tax deduction phaseouts for additional savings.

7. Perhaps you are considering funding a 529 college savings plans for your children or grandchildren. Contributions in some states (including Virginia) qualify for a state tax deduction if executed before the end of the year. Up to $4,000 per account can be taken, with the remaining amount carried forward to future years. Account owners over age 70 are allowed to deduct any amount they contribute to a 529 plan in 2009.

8. Keep in mind that if you make your fourth-quarter state estimated tax payment prior to year-end, you can use it as an itemized deduction next year.

9. You may also give $13,000 per person in 2009 to an unlimited number of individuals without gift tax implications. Families interested in maximizing intergenerational wealth transfers should explore with a professional how trusts can minimize their tax burden and maximize estate planning.

10. Putting investments in the correct investment accounts can also generate significant savings. Fixed-income investments belong in traditional IRA accounts. Interest is taxed at ordinary income tax rates, but the entire value of an IRA account is taxed at ordinary income tax rates anyway upon withdrawal. Appreciating assets should be in taxable investment accounts where the growth will be at a 15% capital gains rate, which is likely much lower than your ordinary income tax rate. Additionally, any foreign tax paid on foreign stock investments is tax deductible in a taxable account. Finally, those investments with the greatest potential for growth belong in Roth accounts where no tax will ever be paid. This tax management alone may boost your after-tax returns by as much as 1% annually.

11. Although small business owners shoulder much of the tax burden, they also enjoy more tax-maneuvering flexibility than other taxpayers. Reducing your taxes may be as simple as deferring income until next year or accelerating Section 179 expenses in the current year.

12. If you own a business, consider stashing cash in a retirement fund to reduce your tax liability. With a solo 401(k), you can contribute to the plan both as the employer and as the employee. As the employer, you can contribute either 20% of self-employment income or 25% of compensation income, depending on your company's structure. Plus, as the employee, you can contribute another $16,000 ($22,000 if age 50 or older). Finally, for the employee portion, tax planning can help you choose between a Roth 401(k) or a traditional pretax contribution.

13. Converting traditional IRA assets to Roth IRA accounts offers a chance for additional tax savings. Couples with an adjusted gross income below $100,000 can always consider a Roth conversion. Next year everyone, regardless of their tax bracket, can convert or contribute to a Roth IRA. And because 2010 is also the last year of the Bush tax cuts, you can use the conversion as a way to avoid the coming tax tsunami in 2011. Make plans now to prepare for next year's conversions.

14. Finally, a complex technique called "Roth segregation accounts" could earn your investments even more savings over the next two years. By segregating your Roth conversions in 2010, you can undo (or "recharacterize") those that underperform and keep the winners. This strategy offers you 20 months to determine which accounts to keep. It's as profitable as betting on the horse race after you know the winner.

Although just a small part of a larger comprehensive financial plan, savvy tax management requires professional assistance. Seek the guidance of a personal fee-only financial planner and certified public accountant (CPA), fiduciaries with a legal obligation to act in your best interests. The laws and ensuing complexities are changing annually, and as a result so is the optimum path.

Comments

[Eric]

Thank god for CPAs hehe :)

[Beastlike]

FMF - please explain!

13 - The tax tsunami - Are they referring to the tax hike BO is going to have to do to pay for all his (wasteful) spending bills? Moreover, so anyone, regardless of net income, can convert their employee 401k's to Roth IRA's?

14 - What does this mean?

[FMF]

Beastlike --

#13 -- That's it (as well as the expiration of the Bush tax cuts).

#14 -- That's a whole post in and of itself. But it basically means you can convert to Roths and then convert back if it's in your best interest. If you need more details, it's probably worth some time with Google.

[Beastlike]

Sounds good - thanks!

[Holly]

These tips are very involved. I was hoping for some enlightening tax-saving shortcuts and information on upcoming changes that may be proposed in 2010. Every time I read an article regarding taxes, the author mentions the AMT (#1), but never tells the reader what it is and how/why to avoid it!

[Apex]

@Holly,

There are always a number of people looking for the quick ways to save money on taxes. H&R Block tries to trick people into using them to do their taxes by claiming they can get you $1,500 dollars extra in refunds over doing it yourself. Like they have some special inside knowledge of the tax secrets. I had a guy I worked with who heard that commercial and decided he was going to take in his taxes to see what they could save him. So I asked him about 5 basic questions to understand if he undertsood the very basics of the tax code and if he had any really strange situations that might allow them to find something drastic that he was unaware of. His taxes (like 98% of people's) were very straight forward and he understood atleast the very basics. I told him they wouldn't be able to save him even 50 bucks and likely nothing. He didn't really like what I told him and basically said he figured they are the experts and if they are advertising for those kinds of savings there must be something they could do.

The next day he wasn't happy. They could not save him 1 penny and he thought they were basically using false advertising.

There are no great special secrets to saving money on taxes unless you have very complicated business or investment situations or entanglements you are willing to endeavor into or you use some more involved techniques such as some of those listed here and even then its not clear if the savings are really there or if its just deferring the inevitable.

Taxes are complicated and unless you do commit tax fraud or hire expensive accountants to devise all kinds of strange schemes and entanglments which are legal but very messy and complicated, you are going to pay what you are going to pay for the most part.

As far as AMT it stands for Alternative Minimum Tax. It's a very old system that was put in place many decades ago to try to prevent rich people from using all these tax schemes and entanglements to get out of taxes so if you made a certain amount of money they required you to pay atleast 26% of your income in taxes after certain allowable deductions and throwing out other deductions (the entanglement types among a fee others). Unfortunately Congress in their wisdom never indexed it to inflation and now its to the point where it can affect 20% of the population or more and that number keeps going up.

Luckily Congress passes a patch every year that gives a large deduction against AMT so that only a few percent (maybe 5 or a little more) actually get hit with it currently. But they need to pass this patch every year because they don't have the courage to fix it as it would require admitting that they deficits will be worse than projected because of all the money they won't get in AMT. However its a lie to not just admit that because they pass the patch every year as it would be political suicide to have 25% or more of the population get his with this "rich" persons tax.

There are no hard and fast rules to determine if it will hit you but if you are married and your income is less than 150k it won't hit you after they apply the patch. Probably if its less than 180K it still won't hit you and its possible to be even higher and not get hit. If you are single those numbers are smaller but I am not sure if they are half or if they are a little higher since I don't file single I am not quite as versed on how easy it is to get hit by it as a single.

Hope that helps with the AMT a little bit. Everyone talks about it like the bit scary beast it could be but because of the patch most people who read about it and wonder about it won't ever have to worry about it. Basically if you get hit with the AMT after the patch, you are already paying quite a lot of tax, you just get to pay a little bit more. No one paying small amounts of tax is in any danger of having to pay AMT.

[Apex]

@Holly,

One more thing. Not to be snarky, but there is mostly only one way to avoid AMT if you are going to be subject to it, and thats to make less money. There are some deductions that apply, so you can gift away a large chunk of your money and that may help, but the thing most people are looking for is how do I make lots of money, keep it available to me, and pay less tax. Answer .... abolish Congress. Otherwise, put on your hard hat and open up the checkbook. Sorry but thems that hard facts.

Here is a good short cut to thinking about getting out of tax.

You will pay less tax if you do 1 of the following things.

1. Make less money, leaving you with less liquid money.
2. Give away more money, leaving you with less liquid money.
3. Purchase govt tax credit products like energy efficient cars, windows, etc. depending on the program, leaving you with less liquid money.
4. Tie up your money in some kind of deferred or investment vehicle (retirement funds, investment property, oil and land use rights, etc, etc, etc), deferring the tax bill until some future date at which it will be paid when you make the funds liquid again, but for the time being it leaves you with less liquid money.

Notice how all 4 end with the same result, less liquid money. I suspect someone can come up with a few situations that don't leave you with less liquid money but thats an almost universal rule. If you want to pay less tax, you have to have less money available to you. If you can get at the money, Uncle Sam will take his cut, no way around it.

[BillV]

Apex,
Smart post, thanks. I have always thought about H&R et. al. Just asking though, what do you consider a small amount of tax?
;->

[Apex]

@BillV

Thats a good question. Obviously its relative to what you make and it depends if you are married with kids etc, but generally a few thousand in federal income taxes I would consider small. My brother makes about 75K is married with 3 kids, decent sized mortgage so after all his deductions and credits he pays almost nothing in federal income tax. A single person with no deductions can start paying tax pretty quickly however. If you only make 20 thousand then a few thousand isn't so small but if you only make 20 thousand you should not be paying a few thousand in tax.

With AMT it's always tough since it's so hard to narrow down when someone will be subject to it but as a general rule if a single person owes less than 10K in federal income tax or a married person owes less than 20K in federal income tax it is not likely they will owe any AMT.

[Holly]

Thanks, Apex. Yes, I understand exactly what you mean...My husband's friend told us to see his accountant and we would see a huge refund. We went to him, showed him 2 previous tax returns (so he could see if we were missing anything), and paid $275.00 only for him to tell us that he might like to hire me since I did such a thorough job on my own (for $13.00 with TaxAct.com).

The refund was typical and he even forgot to deduct that small (about $30.00 excise?) tax we were due from the gov't (had something to do w/telephone taxes)...remember that?

A revelation we have had recently was that my husband's employer offers FSA benefits... he doesn't pay attention to financial issues; it's always up to me to discover these things! I learned that we were missing out on this by reading these PF blogs. Unfortunately, we missed out on this benefit for the last 17 years!!! This is the type of info I thought accountants were supposed to offer.

[Holly]

Sorry, that tax I had mentioned above was a credit (not a deduction).

[Apex]

@Holly,

too bad about the FSA thing.

Some accountants are better than others. Really an accountant is all about knowledge. What does he know that you don't know. That's what you are paying them for. And if you know very little then you probably don't know if they know enough to know what you don't know, ya know? :)

I am not overly impressed with accountants as a rule as many of them seem to just kind of give you minimal information about the exact thing you are talking to them about. They aren't financial planners so often they just add up the numbers you ask them to add up for you. And as a whole, I don't find them particularily good at math either. Thank God they have computers to do the math for them. :)

[Alena]

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Alena