Even though it sounds boring, you can save tax dollars by planning your income and deductions. The general rule is “don’t pay taxes before you have to,” and that’s a good rule to follow. But, let’s look at some situations where it may make sense to pay taxes a little earlier or when it benefits you to do so.
Tax brackets for 2020 for a married couple filing jointly start at 10% and go as high as 37%. There is a steep jump in the tax rate from 12% to 22% when taxable income exceeds $81,050, so how might a taxpayer with income in this range minimize their tax bill? If you expect your income to be well within the 12% bracket in 2021 and expect income to increase in 2022 pushing you into the 22% bracket, using up the lower bracket in 2021 by shifting income recognition can save you money. So, if there was an opportunity to recognize an additional $20,000 of taxable income in 2021 (that would have been recognized in 2022) and stay within the 12% bracket, you could save $2,000 in taxes.
Timing of IRA Distributions
Those reaching age 70-1/2 by December 31, 2019 had to begin taking Required Minimum Distributions (RMD’s) from their retirement accounts and IRAs at that time, and those reaching age 70-1/2 after December 31, 2019 will have to start RMDs at age 72. The IRS has let you defer paying taxes on these earnings to better prepare for retirement, but you have now reached retirement age and they want their tax money. So, whatever the balance of your account was at the end of the prior year, the IRS will estimate how long they expect you to live and require you to take a percentage of your account each year as a taxable distribution. The percentage goes up each year, since you are one year closer to your life expectancy.
As you approach RMD age, we can estimate what your required distributions will be, and considering the tax brackets discussed earlier, it might make sense to take some taxable income before you are forced to take it. Specifically, retired couples in their 60’s who are in a relatively low tax bracket, even considering their combined income from pensions, social security and investment income, may benefit from withdrawing some money from their Qualified Accounts (IRA, 401k, etc.) now to reduce their future RMDs. Each year they can move some funds, net of taxes, to their after-tax account or Roth IRA. Again, great tax savings can be achieved through – you guessed it – Tax Bracket Management!
Converting to Roth IRA/401k
If you are in a lower tax bracket and expect your rates to go higher, this may be the time to convert some of your IRA to a Roth IRA. This can be especially advantageous if you feel that some of your assets are going to increase in value significantly. In that case, convert now at your lower tax rate and the future gains in value will be tax free. The bonus is that you have freedom on when to withdraw because RMD’s are not applicable to Roth accounts.
Qualified Charitable Distributions
Speaking of RMD land, there is an opportunity once you reach this place to avoid the tax on your RMD by donating it directly to a qualified charity via a Qualified Charitable Distribution (QCD). The amount cannot exceed your RMD amount and the contribution must go directly to the charity to avoid taxes. You don’t have to donate the full RMD amount, but whatever portion you choose is tax exempt.
Timing of IRA Contributions
If you are still working or are retired and have earned income from a new job, you want to be sure you make the largest contribution you can to your retirement accounts. If you are in a retirement plan that matches your contributions, go for the max. For your IRA’s you can contribute up to the amount of your earned income, or $6,000 ($7,000 if over 50), whichever is smaller. Depending on your gross income, these contributions may be non-taxable and allow you to save for retirement while reducing your current taxes.
Now Let’s Think About Our Loved Ones
Inescapably as you get older your health starts to deteriorate. If you are caring for a loved one who is in a nursing home, there may be some tax saving opportunities. If your loved one has become dependent on nursing care, he or she may be eligible to deduct the cost of staying in a nursing home. Here’s an opportunity for a person in a nursing home who owns qualified accounts to have the taxable income from withdrawals offset by their qualified medical expenses. So, by choosing to use money from your loved one’s qualified account to pay the bills instead of using cash from their taxable account (i.e. brokerage account), and using the medical expenses as deductions, you can reduce the tax impact of RMDs. The IRS has specific rules for the deductibility of nursing home expenses, but it is an opportunity you should discuss with your financial advisor. This can be especially beneficial when a significant sum is expected to pass to beneficiaries from qualified accounts. Effectively, the loved one is paying the taxes for the beneficiaries.
As always, feel free to contact me or your trusted financial advisor if you have any questions.
Bob Eckenroth | CPA