Savvy Strategies for Tax Season
As Americans begin the tax-filing season, many are looking for ways to reduce their liability to Uncle Sam
To better understand some of the available tax strategies, take a look at how four hypothetical USAA families could lower their tax liability. While they may not match your situation exactly, their situations should give you some ideas about how to potentially keep more of your money no matter what happens Jan. 1.
Married and Military
Nate and Kate: He's a 32-year-old military medic, and she's a 31-year-old elementary school teacher.
Combined salaries: $72,000
Assets: $8,000 in checking and savings, $35,000 in Thrift Savings Plan and 403(b) retirement accounts
Liabilities: $20,000 in student debt, $8,000 car loan, $3,000 on credit cards
Child: Keith, age 4
Nate and Kate are stressed with raising a young child, working long hours and enduring the unique challenges of military life. At the same time, they feel they're finally starting to make some progress in life. They've been saving for five years to buy their first home, while trying to manage cash flow wisely and keep their debt under control. Nate saves 10% of his pay in the Thrift Savings Plan and makes a monthly allotment of $200 to their savings account to keep their cash reserves growing. Last month, he returned from a tour in Afghanistan. While deployed, he set aside his Imminent Danger Pay and some of his other earnings, and now has an extra $8,000 to work with. Kate stopped contributing to her 403(b) plan at work when Keith was born. This year, she started tutoring and expects to earn an extra $8,000 a year.
Strategies that could reduce their taxes.
- Boost retirement contributions. Since they're on firmer financial ground, Kate could consider restarting her 403(b) contributions — aiming for 10% and adjusting it if necessary. That could pare their current tax bill by close to $600.
- Put Nate's combat pay to work. At their income level, Nate and Kate are eligible to contribute to a Roth IRA — which may create a source of tax-free money in retirement. Nate could make the maximum contribution of $5,500 and consider using the rest to pay down debt and build their savings for their first home.
- Look ahead to college. It's not too early for the couple to start planning for Keith's college years. A 529 Saving Plan account may help shield the earnings on their savings from taxes, and withdrawals for qualified expenses are tax-free.
Married with Children
Jim and Stacey: He's a 37-year-old occupational therapist technician, and she's a 35-year-old marketing specialist.
Combined salaries: $105,000
Net worth: $75,000
Children: Ages 2 and 4
Living a modest but contented lifestyle in Alabama with their two kids in a $150,000 home, this couple save 5% in Stacey's retirement plan — but Jim's job has no such benefit. After deductions and exemptions, their taxable income is around $77,000.
Strategies that could reduce their taxes.
- Get serious about retirement. Stacey's 5% contribution rate is a start, but it's not likely to set them up for a comfortable retirement. They should consider aiming higher — at least 10%, if not more. Doubling her contribution rate could save them $700 in taxes next year and slightly less if tax rates stay the same.
- Open a traditional IRA. Since Jim doesn't have an employer-provided retirement account, he can make deductible contributions to a traditional IRA. The contribution limit is $5,500. If they can swing it, hitting the max could save the couple up to $1,540.
- Think about a Roth. While contributing to a traditional 401(k) will slash their taxes in the years they contribute, they could look at putting some retirement money in a Roth 401(k) — if the option is available — or a personal Roth IRA. There's no immediate tax break, but, unlike traditional retirement accounts, qualified withdrawals of earnings from a Roth are tax-free.
- Contribute to a flexible spending account (FSA). If their employers offer FSAs, this choice could cut the couple's taxes while helping with health-care expenses. The contribution limits are $2,500 per plan year per individual. FSAs would let them use pretax money to pay for qualified expenses. If they each participate in an FSA at the maximum $2,500 for a combined $5,000 of expenses, they could save between $1,000 and $1,400 next year, depending on where rates end up.
The Financially Secure Single
Tom: 44-year-old petroleum engineer
Net worth: $150,000
Tom has been renting a condo for a year since he relocated to his job in Galveston. A friend in real estate is nudging him to buy a house for the tax deduction. He contributes 10% of his income to his 401(k) and regularly adds money to his taxable discount brokerage account, where his investments include a tech stock, which is $4,500 underwater and near worthless, and a corporate bond fund.
Filing as an individual, Tom's tax return doesn't benefit from the additional exemptions and larger standard deduction available to taxpayers with a spouse or children. .
Strategies that could reduce his taxes.
- Max out his 401(k). In addition to potentially brightening his retirement picture, contributing more money to a traditional 401(k) also will decrease Tom's current taxable income, since earnings diverted into employer retirement plans isn't taxed by the Internal Revenue Service as current income. If he contributes $5,500 more to his 401(k) — hitting the maximum of $17,500 — he'll potentially save $1,705 in taxes next year. Even if tax rates stay the same, it's still a great idea that will knock $1,540 off his tax bill.
- Consider selling that losing stock. If Tom doesn't have reasonable hopes for a comeback, he could consider closing the books on his disastrous stock pick. By selling, he'll realize a loss that can offset capital gains in his other investments and up to $3,000 of ordinary income.
- Understand the tax benefits of homeownership. Buying a house could create savings on Tom's tax return, since mortgage interest and property taxes are currently tax-deductible. As a single, Tom is entitled to a standard deduction of $5,950. While he can deduct mortgage interest, he should realize it's only valuable to the extent his itemized deductions exceed the $6,300 he could have deducted anyway. Bottom line: Tom shouldn't buy a house just for the write-offs. He also should consider the other costs of homeownership, such as insurance and maintenance, and how long he's likely to own the property.
- Consider buying tax-exempt bond funds. Tom already owns a bond fund for diversification — and now may be a good time to further diversify into tax-exempt bond funds. As the name implies, income from these funds, which invest in bonds issued by state and local governments, is generally free from federal income tax.
- Consider putting off big charitable contributions until January. In a normal year, Tom might rightly focus on making his current-year tax burden as small as possible, which would mean completing his donation before Dec 31. But this is far from a normal year — and if rates rise, his donations will be worth more on next year's return. Take, for example, a $3,000 charitable contribution. Assuming Tom itemizes his deductions, it would save him $840 on his return, when he's in the 28% bracket.
The Well-Off Widower
Dr. Mark: 70-year-old physician who is now retired from the Navy and his medical practice
Annual income from pensions and investments: $85,000
Net worth: $3.5 million
Though Mark's wife died a few years ago, he lives an active lifestyle playing bridge, golf and traveling from his Indiana home to visit his grandchildren in Philadelphia and Tucson, Ariz. He has been a buy-and-hold investor all his life and has more than $1 million each in a traditional IRA and a taxable brokerage account. When his wife died, $1.2 million of her assets went into a trust that provides him a lifetime income. Debt-free, he feels financially secure but wants to ensure his assets someday help his children and grandchildren enjoy the same confidence.
Strategies that could reduce his taxes.
- Consider investment sales. If Mark has thoughts of selling any of his long-held positions outside his retirement account, he may want to do it before Jan. 1, when he faces a possible increase in long-term capital-gains tax rates from the current 15% to 20%. Otherwise, he may be well-advised to keep holding on: When he dies, his capital gains will essentially vanish without income tax — because his heirs get to use the value of his investments on the date of Mark's death when calculating gains and losses.
- Consider moving money into a Roth IRA. If Mark moves some of his traditional IRA money into a Roth — via a conversion — he'll:
- Create an account that offers potential tax-free withdrawals.
- Build a potential source of lifelong, potentially tax-free income for his heirs — since the tax-free nature generally carries over to those who inherit the account.
- Reduce the amount of required minimum distributions from his traditional IRA — there are no such requirements with a Roth during the Roth account owner's lifetime.
- Review legacy plans. Though Mark created a legacy plan several years ago, he should talk to a wealth manager and his tax advisor to see if changes are needed.
- Consider starting a gifting program. One way Mark can decrease his estate tax bill is by giving away money while he's still alive. He can give up to $14,000 each to as many individuals as he likes without triggering gift taxes.
- Watch the calendar when making charitable gifts. Mark usually makes his biggest donations to charity in December, but if it looks like tax rates are going up, he may get a bigger tax benefit by waiting until January.
- Get started on required minimum distributions. Mark turned age 70½ this year, which means it's time to start taking government-mandated distributions from his traditional IRA. While he has an option to defer taking his first required minimum distribution until April 1 and taking his second distribution by Dec. 31 he should consider taking the first one now to avoid pumping up his taxable income next year.