Minimizing tax liability is one of the most important financial planning aspects for business owners and individuals each year, but it can also be a confusing process. Tax credits and deductions are often overlooked when filing taxes each year, and miscalculations or misinterpretations of tax guidelines can end up costing taxpayers more than they may have bargained for. Although it is not exhaustive, the following list of common tax planning strategies can help some taxpayers minimize their taxable liabilities each year.
Increase Retirement Contributions
The easiest way to reduce gross income is through additions to an employer-sponsored retirement plan or contributions to an individually held traditional IRA. Tax benefited plans such as a 401(k) or a 403(b) offered through an employer allow employees to contribute pretax dollars up to a maximum of $19,000 for the 2019 tax year ($18,500 for 2018); for those over the age of 50, an additional $6,000 can be added as a catch-up contribution. 401(k) or 403(b) additions are made through paycheck deferrals and offer a direct dollar-for-dollar reduction to total taxable income, which results in a greatly reduced tax liability each year contributions are made.
If an employer-sponsored plan is not available or an individual is self-employed, contributions can be made to a traditional IRA instead. These additions are also made on a pre-tax basis, resulting in the same direct reduction to taxable income, and ultimately total tax liability. For the 2019 tax year, contributions cannot exceed $6,000, with an additional $1,000 allowed for those age 50 and above.
Transition Non-Qualified Investments
Investment gains derived from dividend and interest payments can be an expensive burden as it relates to total tax liability; however, taxpayers with sizable non-qualified investment accounts can transition assets to vehicles that provide a greater degree of tax shelter. For example, moving from a high turnover mutual fund that is not efficiently tax managed into a tax-exempt bond fund may prove less costly in the long run as dividends and interest are exempt from federal and, at times, state tax. Additionally, selling off investments that have declined in value can help in reducing total tax liability each year, as investment losses can be written off against ordinary income up to a certain limit. It may also be beneficial to hold off on selling an appreciated asset to avoid creating a taxable event in a year when taxable income is already high.
Donate to Charity
Making contributions to qualified charitable organizations can also provide taxpayers with deductions each year. Individuals have the option to donate cash as well as new or used household items to non-profit entities in order to reduce total tax liability. However, any donation that has a value exceeding $250 requires a receipt to be a valid deduction, and donations above and beyond 20% of adjusted gross income are limited.
To reduce tax liability, individuals have the opportunity to take advantage of these tax strategies any time throughout the tax year. The use of a CPA or other tax professional is highly recommended to ensure tax deductions are applied correctly. Similarly, an investment professional may be able to provide additional insight into the most appropriate strategies for restructuring assets during the year.
Mark Struthers, CFA, CFP®
Sona Financial, LLC, Minneapolis, MN
If you’re in a high-deductible health insurance plan, you can open a health savings account (HSA); contributions and distributions are tax-free when used for medical expenses. The same goes for 529 Plans, used for educational expenses. Taxes on the interest earned by Series EE savings bonds can be deferred for 30 years, or until you redeem them. You can avoid taxes on appreciated assets by gifting them to someone, within gift-tax limits. Whenever possible, hold heavily taxable assets in tax-deferred retirement accounts. Just make sure you are not passing up good investment choices or strategies just to avoid giving the IRS its due. Many clients will cut their tax bill to the detriment of sound financial planning. That’s the tax tail wagging the investment dog.