Many people tend to put off several yearly chores—annual physical exams, deep spring cleaning, routine home, and car maintenance, and filing taxes.
It’s easy to adopt a one-track mind when you hear the word taxes, and it’s often always in concert with blushing blooms and allergy season—spring. While filing taxes is a critical component of your financial plan, it isn’t the end-all-be-all of your tax responsibilities.
Proactive tax planning can transform the way you approach your finances from January 1 through December 31.
It’s time to shift your mindset from tax season to tax year. Let’s take a look at four year-round tax tips to keep your money in good shape in any season.
Before implementing any of the ideas we discuss today, consult your tax professional.
Take advantage of tax-sheltered accounts.
Contributing to tax-advantaged accounts is a straightforward and automatic way to actively reduce your income throughout the year.
Most of the accounts below allow you to make tax-deductible contributions, which lowers your annual taxable income. This is important for tax-bracket management and boosting your savings strategy. You can also establish automatic contributions to guarantee that you’re saving consistently month to month.
Consider Maxing-out your 401k
Quick 401(k) recap: Contributions are done as a percentage of your paycheck and are made pre-tax, funds grow tax-free, and distributions are taxed as income in retirement. The contribution limits for 2021 remain the same as 2020, $19,500 with an extra $6,500 in catch-up contributions for those over 50.
Your 401(k) is likely a major player in your retirement savings journey. After years of saving, you’ve likely secured a sizeable balance. It’s essential to make the most of this savings vehicle to grow your nest egg. If possible, work to max out your savings each year. Doing so will not only reduce your taxable income but will also catalyze your retirement savings.
If you can’t max out contributions, try to make sure you’re putting in enough to qualify for the full company match. Employer matches are essentially free money that you can use to support your retirement fund. Tips to stash more away in your 401(k):
- Increase contributions annually
- Boost your percentage every time you get a raise
- Automatically allocate portions of your bonus or extra paychecks to your account
A traditional 401(k) isn’t the only way to go. Some providers allow you to contribute to a Roth 401(k). A Roth 401(k) doesn’t carry the income limits like a Roth IRA and you can contribute well above the IRA limits. While contributions aren’t tax-deductible, earnings and qualified distributions are tax-free. If you’re currently in a lower tax bracket and have a significant time horizon before you need the money, this investment could lead to a significant amount of tax-free dollars in retirement.
Contribute to an IRA
Traditional IRAs operate similarly to a 401(k) with a couple of crucial differences:
- Lower contribution limits ($6,000 with an extra $1,000 if over 50).
- Only some contributions are tax-deductible.
If you make above certain income thresholds and you or your spouse are covered by a workplace retirement plan, odds are you won’t be able to take advantage of deductible contributions to your traditional IRA. Let’s take a closer look at the 2021 figures.
- Single filers can fully deduct contributions if they aren’t covered by a workplace plan. If they are, the following income limits come into play. Partial deductions start once you make over $66,000 per year and stop once you make $76,000.
- If you’re married and filing jointly and one or both of you is covered by a workplace plan, phase-outs for partial deductions begin with a combined income of $198,000. You’re ineligible for deductions over $208,000.
Exceed the threshold? No worries, there are several other ways to lower your taxable income.
Fund an HSA
If you’re enrolled in a high-deductible health plan, you are eligible to contribute to a unique savings account. A health savings account (HSA) is a tax-advantaged investment vehicle designed to help you save for medical expenses. HSAs have triple tax benefits:
- Contributions are pre-tax (a.k.a lowers your taxable income)
- Gains grow tax-free
- Qualified distributions remain tax-free
If you can afford to fund an HSA and still pay current medical expenses out of pocket, consider using the HSA as a long-term investment. You can use the accumulated assets to pay for premiums or other health-related costs in your golden years. You are required to meet co-pays and deductibles for medical costs during working years from after-tax income. In some cases, this could mean over $10,000 for those on a family high-deductible health plan, so you must need to be prepared to meet those costs with cash on hand. There are several ways to invest with an HSA like mutual funds, index funds, etc. Check with your bank/provider to see the options available to you.
An HSA can be an invaluable tool for your retirement savings journey. As medical costs continue to rise, healthcare expenses are top of mind for many pre-retirees. Funds from your HSA can help cover costly medical treatment in retirement.
You can’t contribute past 65, even if you’re working, so building up the fund now could go a long way to keep your retirement budget in check.
The best part? As long as the funds are used for qualified medical expenses, the money is never taxed—something out of a tax dream!
Keep a watchful eye on your Roth accounts.
Proactive tax planning involves making intentional tax choices that will likely benefit you both now and in the future. Roth contributions are after-tax, but gains grow tax-free and qualified distributions remain tax-free, making Roth dollars a powerful instrument in retirement.
Roth IRAs carry strict income limits for regular contributions which bar many high-earners from direct contributions. One potential solution? Initiate a Roth conversion. A Roth conversion allows you to convert all or a portion of a traditional account (IRA, 401k, etc.) into a Roth IRA. You are responsible for paying taxes on the conversion, which makes building a pre-emptive strategy critical.
A Roth conversion might be right for you if:
- You’ve had a low-income year and would pay taxes in a lower tax bracket.
- You want to build up Roth dollars for your nest egg.
- You have time for the investments to compound (cue the 5-year rule).
- Passing down a Roth IRA is part of your estate plan.
Again, this strategy isn’t right for every investor. Be sure to work with your financial advisor and tax professional before initiating a conversion.
A Roth conversion may not be right for you if:
- Converting can push you into a higher tax bracket in the year of the conversion;
- You will need cash on hand to cover the extra taxes in the year of the conversion;
- Your effective tax rate could be lower in retirement than in the current year in which the conversion caused your income taxes to spike.
Build a coordinated financial plan
Proactive tax planning requires multiple professionals to get right. Your financial advisor and CPA should be on the same page when it comes to the strategy for your finances moving forward. When your professionals know each other, you can build a coordinated strategy that brings efficiency to your financial life.
We’re passionate about working with your network of professionals to help you build a tax-efficient and streamlined plan. Stay tuned for part two of our series where we’ll explore two other ways to introduce tax efficiency into your plan all year round.
If you’d like to learn more about how taxes impact your financial plan, set up a call with our team today.
If converting a Traditional IRA to a Roth IRA, you will owe ordinary income taxes on any previously deducted Traditional IRA contributions and on all earnings. A conversion may place you in a higher tax bracket than you are in now. Because Roth IRA conversions may not be appropriate for all investors and individual situations vary we suggest that you discuss tax issues with a qualified tax advisor.
Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.