Hate it or love it, paying taxes is part of life.
But there’s no reason to pay any more in taxes than is legally required.
In fact, finding strategies to reduce taxable income is especially important for people in or nearing retirement who may be adjusting to a fixed income.
As a retirement income expert, I know that there are two things that matter most when it comes to saving for retirement…
Earning more income… and keeping as much of it as possible.
That’s why I’ve put together this simple guide outlining some of the easiest – yet most powerful – ways to save on taxes this year (and beyond).
These strategies will not only help you save on taxes but also help you put more of your hard-earned savings to work creating the retirement of your dreams.
Some of these strategies are little-known. Others are known but often not taken advantage of. But each one is an important tool in your money-saving toolbox.
If you’re already familiar with these strategies and are using them to save big… kudos!
For the rest of you, you’ll want to start applying them immediately.
That way, you can maximize your long-term savings for a truly wealthy retirement.
SAVER’S CREDIT AND EARNED INCOME TAX CREDIT
A strong place to begin is with the “Saver’s Credit.”
It’s a little-known way that the IRS will actually pay Americans to save.
Depending on a filer’s status and AGI, or adjusted gross (taxable) income, the IRS will offer a tiered tax credit from 10% to 50% for savings deposited into an IRA or 401(k).
For example, an individual who is married, retired and filing jointly with an AGI of $50,000, and who doesn’t have to take a required minimum distribution (RMD) from their IRA yet, may decide to contribute $2,000.
(Alternatively, they may be working and contribute this amount.)
This places them in the 10% tier for the tax credit. In recognition of their $2,000 IRA contribution, they will owe $200 less in taxes. There are 20% and 50% credits available for those who make less.
Alternatively, if that individual’s joint income had been $100,000, they would have been disqualified from the tiered tax credit.
The maximums to qualify for the Saver’s Credit are $32,000 for those filing singly, $48,000 for heads of household and $64,000 for joint filers.
If an individual making $100,000 contributes $10,000 to their retirement account using a 401(k), the $10,000 comes off the taxable income value. Only $90,000 will be taxable, which will save $2,200 in taxes for those filing jointly and $2,400 for single filers.
The process is the same for an IRA, although the maximum contribution is $6,000, or $7,000 for those over 50.
Conversely, taxable income is not lowered by contributions to a Roth IRA because withdrawals will be tax-free down the road.
Each different kind of retirement account has its own advantages and drawbacks – and while the tax situations vary, all of them allow for savings to compound protected from the IRS.
Additionally, the earned income tax credit (EITC) can be enormously helpful to people who don’t earn a lot of money. Through the EITC, filers receive money back from the government even if they don’t owe any taxes.
For example, a family of four filing jointly and earning less than $52,493 could qualify for a $5,828 tax credit from the EITC.
The Saver’s Credit and EITC are solid places to begin implementing tax savings strategies for filers who know that they meet required income thresholds.
TAX-EFFICIENT DONATIONS AND GIFTS
The IRS does not look quite as favorably on charitable giving as it used to, but it’s still an important detail to itemize on a tax return. In addition to saving receipts, investors can also make tax-efficient donations using capital gains.
Stock can be donated at any value, but specifically donating appreciated stock that is worth the same amount as a usual cash donation can help investors who are in the habit of supporting a favorite charity lower their taxes at the same time by minimizing their capital gains.
Tangible assets can be donated and itemized as well.
For example, works of art can be donated to a charitable organization, such as a hospital, university or nonprofit. The collector who makes the donation is able to deduct the gift’s fair market value, rather than merely its cost basis, when filing their taxes.
There are two restrictions: The donor must hold the artwork for at least a year before making the donation, and the charitable institution cannot sell the artwork for two years.
Gifts made to and savings accumulated for children and grandchildren through custodial accounts also present opportunities to save on taxes.
Investors can make the gift in the form of appreciated shares instead of selling an asset to fund the gifted account with cash.
The child can then sell at a lower capital gains rate – typically, they will be taxed at 5% instead of 15%.
Instances of charitable and personal giving are additional strong tax savings strategies for investors to begin with because they involve simple itemizations or adjustments to the form of gifts that were already on the investor’s agenda.
When these gifts are itemized and become tax-deductible, all parties benefit.
AVOID PENALTIES
This one might seem like common sense, but you’d be surprised how many people lose sight of easily avoidable holes in their retirement pocket.
Americans who are in or approaching retirement are subject to a variety of rules governing how and when they can withdraw from their tax-deferred or nontaxable accounts.
For example, retired people who are 70 1/2 or older must begin to make RMDs from most kinds of retirement accounts.
However, an investor who is required to make a $10,000 withdrawal from their IRA who also plans to donate $1,000 to their favorite charity without itemizing can combine these goals in one transaction.
They will benefit from a $1,000 reduction, representative of the donation, in the amount of the required withdrawal that will be taxable. For an investor in the 24% tax bracket, this amounts to $240 in taxes.
This is particularly important for those who are nearing 70 1/2 because taxable thresholds were never indexed to inflation. Retired people who are 70 1/2 or older lose control over the amount that they must withdraw yearly from tax-deferred accounts and risk finding themselves in a higher tax bracket as a result.
Penalties for failing to make an RMD can be severe, so it is important for seniors to adhere to their deadlines; however, there are additional strategies they can use to reduce their risk of finding themselves in a higher tax bracket.
For example, distributions do not have to be made in cash; securities of the same value can be transferred instead. They can also be withdrawn at any time of year as long as the first withdrawal takes place before the investor turns 71 1/2.
Therefore, if the investor waits for a down period in the market when their assets have dipped in value and then transfers securities that are equal in value to the RMD, it serves as a form of dollar-cost averaging and allows them to transfer more than if they had transferred securities during a high point.
While this strategy won’t lower the investor’s immediate taxes due for that year, it will reduce the amount remaining in the tax-deferred account that must be distributed.
In addition to minimizing penalties and taxes incurred by RMDs, it is also important for investors to avoid the alternative minimum tax, or AMT.
Individuals who meet minimum adjusted income values between $51,000 and $400,000, take many miscellaneous deductions, exercise stock options and claim business depreciation are most likely to face this penalty.
If assigned this penalty, these filers will be locked out of common deductions like local tax payments and healthcare expenses – so for these investors, it may be wiser to claim the standard deduction.
Another penalty that investors should be aware of is the “kiddie tax.”
At one time, it was common for individuals to open investment accounts in their children’s names. Sometimes this was to simplify estate planning, but it also served as a common tax-avoidance strategy because children’s incomes previously qualified for a 0% capital gains rate.
However, the government responded to this practice in the ’80s with the implementation of the “kiddie tax.” Under this provision, a child’s income above $2,100 is now taxed at their parent’s rate.
A “child” is defined in this law as an individual under 24 if a full-time student and under 19 otherwise.
Investors tempted by this strategy are unlikely to be able to implement it without incurring taxes. Instead, they should consider setting up a tax-advantaged college savings account, like a 529.
ALTERNATIVE SAVINGS ACCOUNTS
If you have a high-deductible health insurance plan, you can make pretax contributions to a health savings account (HSA). These funds can be used toward upcoming medical expenses.
Like a 401(k), an HSA is tax-sheltered. Any contributions are deducted from the filer’s gross income, which lowers your taxable income.
The only requirement is that to remain tax-free, they must be used on qualifying medical expenses.
For example, a filer in the 24% tax bracket who contributes $2,000 to an HSA will reduce their annual gross income by $2,000, and by extension reduce their taxes by $480 (24% of $2,000).
If they then incur $1,500 in medical expenses that are not covered by insurance because of the deductible, copay or other reasons, they can pay the $1,500 from their HSA account and keep $500 in the account for the next year.
If the account holder passes away before they can use all of the funds, their beneficiary can inherit the account as their own HSA without paying an estate tax.
An additional benefit of contributing to an HSA is that the funds can be invested. The account can even be used as a supplemental 401(k) or IRA.
Filers who have met their maximum contribution to an IRA or 401(k), after meeting a designated balance, can invest the funds in their HSA and develop an auxiliary nest egg for retirement.
However, if an expensive health emergency does come up, they can still use the HSA.
After age 65, HSA funds can be withdrawn for nonmedical expenses, but they will be taxed. If they are withdrawn for nonmedical expenses before age 65, they will incur a 20% penalty.
While it may seem limiting that the funds can be used for only medical expenses, the fact is that the average couple will spend $390,000 on healthcare-related expenses in retirement.
HSAs are an effective and tax-efficient way to meet that need.
Additionally, individuals who are not on high-deductible health insurance plans may still have the option of establishing a flexible spending account (FSA) for dependent care or healthcare.
Like an HSA, an FSA takes the funds that an individual was already planning to spend on healthcare and puts it in an account pretax, lowering their taxable income.
A filer earning $75,000 who expects to spend $5,000 per year on healthcare can have $5,000 deducted from their paycheck and prorated throughout the year. However, instead of reporting $75,000 in income to the IRS, they will be able to report only $70,000 because $5,000 was already taken out of their income.
That lowers their tax bill by $1,250 simply by putting money they were going to spend anyway in a separate account.
Investors who are concerned about rises in tax rates that might occur before they are required to begin withdrawing funds can also look into an “after-tax” saving strategy. For example, they can contribute to a Roth IRA if they meet the income requirements, or they can convert to a Roth IRA in retirement.
With these strategies, it’s important for investors to keep in mind that they probably won’t have as many tax deductions in retirement. For example, it is common to pay off home mortgages before retirement, which means seniors won’t have the deduction of their mortgage interest to help offset their tax liabilities.
Part of planning a tax-efficient retirement involves taking advantage of all available opportunities to contribute pretax to a nest egg, but investors should also create savings plans that address any concerns they have.
BUILDING A TAX-EFFICIENT PORTFOLIO
In addition to optimizing the tax-efficiency of their savings accounts, individuals should also take steps to ensure that their portfolios are distributed as efficiently as possible between taxable, nontaxable and tax-deferred retirement accounts.
Many investors are unsure how to accomplish this.
While they may already have established both accounts that are taxable (like a brokerage account) and ones that are nontaxable or tax-deferred (like a traditional 401(k) or IRA), they may be uncertain about which investments are most tax-efficient in each kind of account or which investment vehicles are most naturally tax-efficient.
For example, most long-term investors who don’t plan on selling many stocks during the year will have more dividend or interest income than capital gains.
In that case, they’re better off allocating those income-producing investments in tax-deferred accounts.
In Your Tax-Sheltered Account: Dividend Payers
To begin, one of the most beneficial things an income investor can do for their portfolio is establish a dividend reinvestment plan, or DRIP.
This involves automatically reinvesting all dividends that the shareholder receives back into the stock no matter what the market is doing or where the stock’s price is headed.
This means that when the market is up, the investor will be buying fewer shares. When it is down, they will be buying more, and buying them at a bargain.
If an investor establishes a DRIP in a tax-deferred account, they will be spared the yearly 15% dividend tax that they would’ve had to pay if they held the stocks in a taxable account.
These savings compound over time because the amount that would have been lost to taxes is subject to compounding as much as the rest of the return.
The tax rate on dividends for most people is 15%, so if the investor stood to lose 15% of their dividend income yearly to taxes, their total loss over time would be significantly more than 15%.
If they bought $10,000 worth of stock that had a 4% dividend yield and held it in a tax-deferred account, and over 10 years the stock rose at the same rate as the S&P 500’s historical average, they would have accumulated $27,854 after 10 years.
If they had to pay a 15% tax on the dividend every year, they would have finished with $26,683 – nearly $1,200 less.
In Your Tax-Sheltered Account: REITs and Mutual Funds
Other tax-efficient investments that are strong choices for a tax-deferred account are real estate investment trusts, or REITs. REITs allow multiple investors to buy shares in a portfolio of real estate properties and receive 90% of the trust’s profits back in dividends.
They function like a dividend stock, but often with a higher yield and payout ratio.
However, position sizing is still critical: REITs are susceptible to interest rate fluctuations, so overexposure to them prevents investors from properly diversifying their portfolios.
Mutual funds’ annual returns take operating costs (expenses) into account, but they do not consider taxes. For this reason, two funds with identical net returns can deliver drastically different returns after taxes.
Mutual funds are required by law to distribute at least 90% of their realized gains each year, so investors can face a tax bill even if they haven’t sold a share.
For this reason, mutual funds are best kept in tax-sheltered accounts.
In Your Tax-Sheltered Account: Non-Municipal Bonds
Additionally, most bonds also belong in a tax-deferred account when possible. They should even be prioritized over dividend payers because bonds are taxed at the ordinary income tax rate while dividends are taxed at 15% for most people.
Because there are limits on contributions made to a tax-deferred account, it is important to prioritize protecting the income that is subject to the highest tax rate.
For example, Treasury Inflation-Protected Securities’ (TIPS) semiannual interest payments are taxable. However, investors are also taxed on annual inflation adjustments to the principal. This process is commonly described as taxing “phantom income,” and it is a reason to hold inflation-adjusted Treasurys in a tax-deferred account.
Additionally, exchange-traded funds (ETFs) that invest primarily in TIPS, like the iShares TIPS Bond ETF (NYSE: TIP), are available to investors.
U.S. Treasury Series I savings bonds are another worthwhile option. They pay a rate of return that is set to the cost of living and inflation, and the return can be tax-deferred for many years.
Other tax-inefficient assets include corporate and U.S. government bonds. Here, the majority of the return comes from interest income, and all of it is taxable.
Income funds will typically make capital gains distributions from time to time as well, so they also belong in a tax-deferred account.
Municipal bonds, however, are naturally tax-deferred and therefore belong in a taxable account, like a brokerage account. Tax-free bonds have the added benefit of being very stable.
Nontaxable? Or Tax-Deferred?
Note that there’s a difference between “nontaxable” and “tax-deferred.” A 401(k) is considered a tax-deferred account because contributions come out of the filer’s paycheck pretax and are taxed on withdrawals they make in retirement.
A Roth IRA, however, is an example of a nontaxable account because contributions are made after tax. The withdrawals made in retirement are not subject to tax, so reinvesting dividends in a Roth IRA is another way to minimize taxes on compounding returns.
Nontaxable and tax-deferred accounts aren’t solid choices just for income generation; they’re also the best bet for most other investments.
There are a few specific exceptions.
In Your Taxable Account: Equity Index Funds and Return of Capital
Taxable accounts make more sense for investments that the purchaser intends to hold for at least a year. This is because unrealized gains, also known as capital appreciation, offer the benefit of tax-deferred investing.
However, for short-term investments, taxable accounts are not the best option. Gains on securities held short term are taxed at higher ordinary income rates. Therefore, tax-deferred and tax-exempt accounts make sense for active traders.
While dividend-paying stocks, REITs, bonds and most other investments thrive best in a nontaxable or tax-deferred account, there are a few cases of investment vehicles that should actually go in taxable ones because they are naturally tax-deferred.
For example, equity index funds, which are already highly tax-efficient, and individual stocks, which an investor anticipates holding long term, are best suited for a taxable, non-retirement account because the investor is able to control their capital gains tax liability and offset realized gains with realized losses where possible.
If a dividend consists mostly of return of capital, it is already tax-deferred. If it is being held in a tax-deferred account, it may take the place of a less tax-efficient investment that should be in a tax-deferred account.
In Your Taxable Account: MLPs
One of these types of investments is a master limited partnership, or MLP. MLPs represent a collection of stocks, usually in the energy sector. And they pay their own kind of dividend, which is referred to as a distribution.
Distributions paid by an MLP are themselves tax-deferred because they are considered return of capital.
A shareholder of an MLP will pay capital gains tax on the stock when it is sold. But the entire time that it is held, they will not pay tax on the return of capital portion of their income, so it’s not necessary to shelter it from tax in an IRA or 401(k).
Because an MLP’s distributions are tax-deferred, they lower cost basis. This means investors will theoretically have a larger capital gain when they sell the stock – but in the meantime, they are accumulating tax-deferred income.
However, MLPs can be volatile. When energy prices fall, MLPs typically drop as well. Therefore, an MLP can be a strong addition to an income generation portfolio, but it is dangerous for investors to find themselves overweight in that sector.
In Your Taxable Account: UBTI and Most International Stocks
Additionally, some stocks that have a return of capital component to the dividend generate something called unrelated business taxable income (UBTI). If an investor holds $1,000 in UBTI in their tax-deferred account, they’ll likely have to pay tax on that money, and possibly penalties as well.
International stocks are also strong candidates for a taxable account. Many international stocks have taxes taken out of their dividends by their home countries before U.S. investors receive them.
If those stocks are held in a taxable account, the investor will get a credit for that money on their taxes; however, if those stocks are held in a tax-deferred account, the foreign government will still take the tax out of the dividend, but U.S. investors will not receive a tax credit from the IRS.
One exception to this rule comes from dividend-paying stocks based in the U.K., like GlaxoSmithKline (NYSE: GSK). Though the company is based in Brentford, England, and would qualify as an international stock, the U.S. holds a trade treaty with the U.K. where the U.K. will not take taxes out of U.S. investors’ dividends.
Therefore, it is most tax-efficient to treat dividend-paying stocks from the U.K. the same way you would treat domestic ones and save on your taxes by automatically reinvesting the dividends you receive in a nontaxable or tax-deferred account.
Investors can also consider ETFs that are specifically designed to limit tax impact. There are as many ways to build a tax-efficient portfolio as there are investors, so it is important to consider each individual’s needs and concerns and tailor their accounts accordingly.
MISCELLANEOUS CREDITS
Medical expenses take too many retirees by surprise, but it’s possible to mitigate some of those expenses by claiming a few qualifying ones.
In fact, any medical, dental, surgical, transportation or even alternative medical expenses that exceed 10% of adjusted gross income (AGI) are eligible.
AGI is the portion of a filer’s income that is taxable. It’s a representation of what they have earned after pretax deductions, like tuition or 401(k) contributions, have been taken out.
That means while an individual may earn $50,000 yearly, after deducting pretax contributions, such as to a 401(k) or IRA, their AGI might be closer to $45,000.
If their filing status is single and their AGI amounts to $45,000 yearly but an unexpected surgery puts their total medical spending above $3,375 for the year, any expenses incurred beyond that $3,375 would be tax-deductible. However, they must be itemized.
This policy of including alternative medical expenses even covers needs like acupuncture, herbal remedies, nicotine patches and service animals.
That said, insurance won’t always cover these kinds of expenses, so it is best to check with an accountant or the IRS to confirm that the deductions are eligible.
Additional miscellaneous tax credits cover the following costs.
- Electric Vehicle Tax Credit: Purchasing some models of electric cars can qualify the buyer for up to $7,500 in tax credits.
- Volunteer Supplies: If a volunteer purchases supplies for a charity, or for themselves while supporting one, the cost is deductible. For example, if a volunteer needed to buy a hairnet and gloves while working at a soup kitchen, the cost of the gloves and hairnet would be considered a charitable donation.
- Alimony: Alimony payments lower taxable income. Note that this is separate from child support.
- Sales Tax: Sales tax paid on high-priced purchases like cars, furniture or weddings can be itemized and reduce taxes.
- Aging Parents: Those who care for an aging parent may be able to claim them as a dependent, particularly if the filer is paying for much of their parent’s necessary care.
- Business Write-Offs: This is an easy deduction to forget, but an important one nonetheless. Business, and even job-seeking, expenses can often be deducted. Additionally, filers who have a business and a home office can deduct a portion of their mortgage or rent, utilities, insurance, and maintenance costs. The IRS looks for people abusing this allowance, so it is important to be precise, but those items can add up to hundreds or even thousands in tax savings during the year.
OFFSET CAPITAL GAINS
It’s important for investors to offset any realized capital gains using other parts of their portfolios. One simple way to do this is to strategically realize losses. This technique is called tax-loss harvesting.
The IRS allows filers to offset realized capital gains each year by selling any losing positions. (Additionally, individuals can take an additional $3,000 in losses against earned income.)
But they must wait 30 days before buying back these securities – otherwise, they will run afoul of the wash-sale rule and lose the ability to claim the loss for tax purposes.
One Final Note…
It is important for workers to take full advantage of their 401(k) retirement accounts – especially those 50 or older who require additional savings and qualify for “catch-up” contributions.
However, the limits of saving for retirement don’t end with a 401(k). After an individual has met the maximum contributions toward their 401(k), they can still contribute fully to an IRA. The contribution won’t be tax-deductible, but their investment will still compound tax-deferred.
The benefits of this strategy compound over time: An individual who contributes 15% of their gross income to their 401(k) receives a return of about 60% of their contributions from tax breaks over the course of their working life.
For example, in one year making $70,000, an individual in the 22% tax bracket who contributes 15% to their retirement plan will receive a $2,310 return on their $10,500 contribution.
This does not account for deductions, state and local taxes, or tax differences between capital gains and interest. A 7% return on the invested $10,500 would lead to a $735 profit and, by extension, $161 in tax-deferred gains, for a total tax savings of $2,742.
Over time, this will have a notable effect on the overall cost of the contributions. For example, contributing 15% yearly on $70,000 of income over 30 years adds up to $315,000 in total contributions. An average return of 7% per year would leave this investor with a $1.1 million nest egg.
The yearly growth represents $746,000 of the total, which has accumulated tax-deferred for 30 years. Eliminating capital gains calculations for simplicity, this would lead to a tax savings of $164,000 for an individual in the 22% tax bracket.
The savings are even more dramatic in a Roth IRA, which, unlike a tax-deferred conventional IRA, allows investors to take tax-free distributions.
Because contributions are made after-tax, after age 59 1/2, investors can make withdrawals from an account that has been growing growth, income, interest and capital gains tax-free.
Individuals who convert to a Roth from a conventional IRA will pay income tax on any untaxed funds they move, but they will be eligible for the same tax benefits once their Roth IRA is established. Converting may move them into a higher tax bracket, so they may benefit from waiting until they are in a lower one, but their savings over time could counterbalance this difference. There is also no RMD.
That is why many investors who did not previously have a Roth IRA opt to convert to one during the first year of their retirement. They will face a lower tax bill and avoid RMDs and taxes on growth during retirement.
It is important to do this early, however, because funds must have been in the Roth IRA for five years before they can be withdrawn tax-free.
SUMMARY
Now let’s bring everything together.
- Saver’s Credit and Earned Income Tax Credit: You can lower your adjusted gross income (AGI) by 10% to 50% of your savings deposited into an IRA or 401(k) – depending on your filing status – with the Saver’s Credit. In addition, if you don’t earn much money, you can use the earned income tax credit (EITC) to receive money back even if you don’t owe taxes.
- Tax-Efficient Donations and Gifts: You can also lower your taxable income by itemizing the value of your charitable giving. This includes investments with capital gains, which can be gifted as well.
- Avoid Penalties: Be sure to meet minimum distribution requirements from your IRA or 401(k) to avoid paying severe penalties – especially for folks nearing age 70 1/2.
- Alternative Savings Accounts: Take advantage of health savings accounts (HSA) and flexible savings accounts (FSA) to make pretax contributions that lower your AGI while also setting money aside for healthcare expenses not covered by high-deductible insurance plans.
- Building a Tax-Efficient Portfolio: Buy and hold income-paying investments such as dividend stocks, mutual funds, real estate investment trusts (REITs) and non-municipal bonds in tax-advantaged or tax-deferred accounts. Alternatively, keep equity index funds, master limited partnerships (MLPs), unrelated business taxable income (UBTI) and most kinds of international stocks (excluding dividend-paying U.K. stocks) in a taxable brokerage account.
- Miscellaneous Credits: Take advantage of costs that can be written off to lower your tax burden, such as the cost of volunteer supplies, alimony, sales taxes, taking care of dependent aging parents and business write-offs. If you’ve recently purchased an electric vehicle, be sure to use the electric vehicle tax credit – which qualifies you for to up to $7,500 in tax credits – before this credit gets phased out.
- Offset Capital Gains: Use tax-loss harvesting to deduct the value of your investment losses to further lower your realized capital gains.
Combining these strategies is a powerful way to save and compound your wealth-building efforts toward retirement. Even using just one of these strategies to save will prove beneficial in the long term.
So be sure to take full advantage of these ways of lowering your tax bill.
It’s your legal right!
P.S. I’ve been working for months on a secret income project, and I just hit a breakthrough.
“Since publishing my book, Get Rich with Dividends, I’ve helped thousands of people achieve their retirement goals.
And today, I’m going to share with you perhaps one of the most astonishing income strategies I’ve ever uncovered from our trusted partner, Alexander Green – Chief Investment Strategist at The Oxford Club.
Check out Alex’s presentation on what he’s calling “The Single-Stock Retirement Play”
This may help end the retirement crisis in America.
Hoping these tips help you, and looking forward to hearing from you soon,
Marc Lichtenfeld
Chief Income Strategist, The Oxford Club