Strategies to Tame the Tax Beast

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Here are five hypothetical scenarios to illustrate how you could more effectively direct money and manage taxes. The scenarios may not match your situation, but they should provide ideas on how you may be able to work toward your financial goals. It's also important to note that the suggestions listed are not the only changes you should consider making but are important in light of the recent tax law changes.

Single in the Military

Sarah: She's a 24-year-old petty officer third class. Salary: $35,000. Assets: Checking and savings, $1,000; TSP, $2,000. Liabilities: Car loan, $9,000; Credit cards, $4,000

Sarah began noticing she consistently used savings and credit cards to help her pay monthly bills, purchase necessities and travel home to St. Louis to visit friends. This year Sarah wants to better understand where she spends her money and to establish a budget that injects more discipline into her finances. Sarah's time away from home due to deployments and training diminishes her ability to consistently focus on her finances. She saves 6% of her salary in the TSP.

Strategies that could address concerns and manage taxes

  • Create a budget. Creating and adhering to a budget will help Sarah not only understand where her money is spent but also help her manage future spending. This will eventually allow Sarah to own more than she owes as she begins to carry less debt.
  • Have an adequate emergency fund. Using credit cards to pay for emergencies creates a false sense of financial security. Sarah should implement a plan for saving six months of living expenses. She could consider a savings account, short-term CD or other liquid investment for these assets.
  • Consider saving for retirement in a Roth. Sarah's low tax bracket wasn't affected by the recent law changes. This means the current tax savings associated with her 5% pretax contribution to her TSP is minimal, so changing to Roth TSP contributions could make sense. With the Roth TSP, Sarah wouldn't get a current-year tax deduction but has the potential to access her contributions and earnings tax-free at retirement. Since the TSP doesn't provide her with a matching contribution, she also has the alternative of opening a Roth IRA, which provides more investment choices and access than the Roth TSP. To ensure appropriate asset allocation and management in context of her retirement date, she could consider investing Roth IRA contributions in investments matching her risk tolerance.

Young, Married and in the Military

Nate and Kate: He's a 30-year-old military medic; she's a 27-year-old retail manager. Combined salaries: $85,000. Assets: Savings, $45,000; Nate's TSP, $2,000, pretax contributions. Liabilities: Student loans, $20,000; credit cards, $3,000. Financial concerns: Saving for a new home, investing for retirement and paying off debt.

Both agree they need a more disciplined approach toward finances and a plan to address their goals. They've been saving what they can in bank accounts plus 10% of Nate's salary in his TSP. Nate just returned from Afghanistan and deposited an additional $15,000 into their savings account. Kate has not saved anything for retirement.

Strategies that could address concerns and manage taxes

  • Adjust their budget. The new laws didn't extend the payroll tax holiday. Social Security taxes have increased from 4.2% back to 6.2%. This means Nate and Kate will need to adjust their spending to account for a $1,700 reduction in annual pay.
  • Pay off debt. They should consider paying off their credit card balance if it has a high interest rate, and making additional payments toward Kate's student loan. They can continue to deduct up to $2,500 in interest from Kate's student loan based on their joint income level.
  • Consider investing with an eye on taxes. The tax law changes did not change Nate and Kate's tax bracket, and while the act increases taxes on capital gains and dividends from 15% to 20% for some taxpayers, Nate and Kate are not affected. To reduce current taxes and address their retirement planning concerns, Nate could increase his TSP contribution. If future taxes are more of a concern, Roth TSP or Roth IRA contributions could be considered.

Married with Children

Jim and Stacey: He's a 37-year-old occupational therapist technician, and she's a 35-year-old marketing specialist. Children: Ages 8 and 4. Combined salaries: $150,000. Assets: Savings, $81,000; Jim's 401(k), $20,000 (target retirement fund and cash); Stacey's 401(k), $30,000 (target retirement fund and cash accounts). Liabilities: Credit card, $10,000; car loan, $20,000. Financial concerns: Potential stock market declines, appropriate retirement account allocation, saving for college and saving for a new home.

Currently, 50% of their 401(k) is in a target fund and 50% is in cash. They intend to return to U.S. equities once they feel that the political and economic environment improves. .

Strategies that could address concerns and manage taxes

  • Take advantage of child-care deductions and child tax credits. Depending upon their income and child-care expenses, they could qualify for a tax credit of up to 35% of these expenses. These laws were continued as part of the recent tax legislation.
  • Consider saving for college. There are several ways that they can save for college. Generally, these solutions are affordable and can be opened with as little as $50.
  • Consider investing the cash in their 401(k) retirement account. Their retirement accounts shouldn't be accessed for at least 30 years. This means the short-term volatility associated with a diversified portfolio should not serve as the benchmark for investing success. Their 401(k) investment should be part of a retirement plan that takes into account their goals, investment objectives and risk tolerance.

The Financially Secure Couple

Tom and Jennifer: He's a 45-year-old petroleum engineer; she's a 40-year-old college professor. Combined salaries and income: $325,000 (includes Tom and Jennifer's salaries plus investment income). Assets: Savings, $50,000; Tom's Roth 401(k), $200,000 (bond fund and cash); Tom's IRA, $200,000 (target fund and cash accounts); Jennifer's 401(k), $100,000 (money market, international fund and a bond fund). Liabilities: None. Financial concerns: Convinced a market crash is coming.

From September 2008 to March 2009, they watched the financial markets and their accounts drop by more than 47% before reluctantly recognizing their losses and reinvesting in money markets and bond funds. Now, the new tax laws, 3 1/2 years of high unemployment, a still-declining housing market and looming debt-ceiling discussions have them convinced another severe market downturn is inevitable. Given this, they want to continue their "wait-and-see" approach with their retirement portfolio.

Strategies that could address concerns and manage taxes

  • Consider reallocating 401(k) and IRA accounts into diversified portfolios. Their retirement accounts won't be accessed for at least 20 years. Short-term volatility associated with a diversified portfolio should not serve as the benchmark for investing success. Their 401(k) and IRA investments should be part of a retirement plan that takes into account their goals, investment objectives and risk tolerance.
  • If eligible, consider contributing more to their 401(k) accounts. Maximizing the contributions can reduce their taxable income and potentially lessen the impact of the 3.8% Medicare surtax. They both can fund their 401(k) accounts up to $17,500.
  • If Tom's 401(k) plan allows, consider a 401(k) Roth conversion. Tom and Jennifer's income disqualifies them from funding Roth IRA accounts. Still, Tom can transfer his pretax and company matching contributions into a designated Roth account within the same plan. He'll have to pay federal income taxes on the amount converted, but qualified distributions from the Roth account in the future will be potentially tax-free income. In addition, the 10% early distribution penalty doesn't apply to amounts converted. This new law also applies to 403(b) and 457(b) plans that allow Roth contributions.
  • Develop an ongoing plan with a tax and financial advisor. By working with these professionals, Tom and Jennifer may learn they haven't incurred any capital gains. Any capital gains will be taxed 20% as long as their income remains less than $450,000. Tom and Jennifer would have also learned their exposure to the 3.8% Medicare surtax was minimal despite their income exceeding $250,000. Coordination by their financial team may help them invest with tax efficiency.

The Well-off Widower

Dr. Mark Atkinson: A 73-year-old private-practice physician and retired U.S. Air Force Reserve lieutenant colonel. Mark's salary and income: $570,000 (includes salary, military retirement pay, Social Security, retirement account required minimum distributions and net investment income). Net worth: $4.5 million. Assets:

  • Primary residence: $600,000.
  • Savings account: $300,000.
  • Traditional IRA: $800,000 ($400,000 in index funds and $400,000 in cash).
  • 401(k) plan: $800,000 ($640,000 in stock mutual funds and $160,000 in cash).
  • Taxable brokerage account: $2 million ($1.3 million in taxable bonds, $700,000 in cash accounts.).

Financial concerns: Thinks he no longer needs to take risks with his investments but isn't sure.

Mark feels he mostly "dodged a bullet" during the recent recession because when it hit, he had his 401(k), IRA and taxable brokerage accounts invested in a diversified portfolio with a large amount in cash accounts. He feels somewhat relieved he has recovered some of the value temporarily destroyed by the "Great Recession," but he is concerned that another severe market downturn could jeopardize his wealth.

Strategies that could address concerns and manage taxes

  • Invest cash in retirement accounts. Mark has $560,000 in cash and cash equivalents within his tax-deferred retirement accounts. The new laws mean higher taxes on income, dividends and capital gains for Mark. Depending on his objectives and risk tolerance, he could allocate the cash in his retirement plans to investments that generate income and dividends. These investments would generally be taxed at higher rates in nonretirement accounts and, in light of the new tax laws, might be better positioned in tax-deferred accounts. Examples include taxable bond funds and dividend-paying stock funds.
  • Consider repositioning to tax-exempt municipal bonds to help minimize taxes. Making a change to tax-exempt bonds could reduce net investment income and minimize exposure to the 3.8% Medicare surtax.
  • Consider investing in a professional managed account. Mark is a busy physician and previously has kept a large amount of assets in cash because of his constraints on time, desire and expertise.
  • Regularly consult with his tax advisor and wealth manager. Coordination with his financial team will help Mark invest appropriately with tax efficiency. His advisors can develop a plan for managing income, which is taxed at both the highest tax rate of 39.6% and the 3.8% Medicare surtax, as well as a plan for capital gains, which are taxed at 20%. In addition, this team can help Mark develop a legacy plan for family and charities, in light of the tax law's increase in estate taxes from 35% to 40%.


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