Fourteen Tax Management Techniques

with 2 Comments

Dorothy AMT tax formNo one approaches financial planning with the goal of paying more taxes. Tax management, like all financial planning, is based on the premise that small changes made over time can achieve big goals. Good investment returns are important. But over the next few years, comprehensive tax management may reap even greater gains.

Don’t file your taxes in April and then forget about them for the next 10 months. By investing a little time throughout the year, you can create compounded value. The 14 techniques described here may help you lighten your tax burden.

1. Check line 45 on your 2008 IRS form 1040 to see if you paid any alternative minimum tax (AMT) last year. People subject to AMT pay an average of $6,000 more than they would otherwise. AMT turns tax planning upside down. Because conventional wisdom may not apply, be sure to review your financial affairs with a professional.

2. This year offered a spectacular opportunity for realizing capital losses. Realized losses can offset realized gains. They can also be deducted against ordinary income up to $3,000 a year. Any excess above $3,000 is carried forward and can be deducted in future years.

3. You can realize capital losses and still stay fully invested. Sell the security, and then wait 31 days before buying it back. Alternately, double up. Purchase the same number of shares you currently hold. Wait 31 days. Then sell the original shares for a tax loss. Waiting a month between the sale and the buyback avoids a so-called wash sale, which would prevent you from taking the tax loss.

4. Individual stocks offer more opportunities to realize capital losses or gift capital gains. This is useful primarily in larger portfolios. A portfolio of individual stocks collectively may mimic the return of an exchange-traded fund and still provide additional tax savings. For example, although the total return might be 10% for the year, one of the individual stocks has doubled and two others lost 50% of their value. By holding individual stocks instead of the fund, you are able to sell the two stocks that have a 50% negative return and take the loss on your taxes. Holding the stock that has doubled in value postpones paying capital gains.

5. Using appreciated stock for charitable giving can avoid paying capital gains entirely. This allows you to contribute up to 15% more than you could with a cash gift.

6. This year also extended the opportunity to make qualified charitable distributions. If you are 70 1/2 or older, gifts you make directly to charity from your IRA are not counted as income. In this way you can reduce your tax deduction phaseouts for additional savings.

7. Perhaps you are considering funding a 529 college savings plans for your children or grandchildren. Contributions in some states (including Virginia) qualify for a state tax deduction if executed before the end of the year. Up to $4,000 per account can be taken, with the remaining amount carried forward to future years. Account owners over age 70 are allowed to deduct any amount they contribute to a 529 plan in 2009.

8. Keep in mind that if you make your fourth-quarter state estimated tax payment prior to year-end, you can use it as an itemized deduction next year.

9. You may also give $13,000 per person in 2009 to an unlimited number of individuals without gift tax implications. Families interested in maximizing intergenerational wealth transfers should explore with a professional how trusts can minimize their tax burden and maximize estate planning.

10. Putting investments in the correct investment accounts can also generate significant savings. Fixed-income investments belong in traditional IRA accounts. Interest is taxed at ordinary income tax rates, but the entire value of an IRA account is taxed at ordinary income tax rates anyway upon withdrawal. Appreciating assets should be in taxable investment accounts where the growth will be at a 15% capital gains rate, which is likely much lower than your ordinary income tax rate. Additionally, any foreign tax paid on foreign stock investments is tax deductible in a taxable account. Finally, those investments with the greatest potential for growth belong in Roth accounts where no tax will ever be paid. This tax management alone may boost your after-tax returns by as much as 1% annually.

11. Although small business owners shoulder much of the tax burden, they also enjoy more tax-maneuvering flexibility than other taxpayers. Reducing your taxes may be as simple as deferring income until next year or accelerating Section 179 expenses in the current year.

12. If you own a business, consider stashing cash in a retirement fund to reduce your tax liability. With a solo 401(k), you can contribute to the plan both as the employer and as the employee. As the employer, you can contribute either 20% of self-employment income or 25% of compensation income, depending on your company’s structure. Plus, as the employee, you can contribute another $16,000 ($22,000 if age 50 or older). Finally, for the employee portion, tax planning can help you choose between a Roth 401(k) or a traditional pretax contribution.

13. Converting traditional IRA assets to Roth IRA accounts offers a chance for additional tax savings. Couples with an adjusted gross income below $100,000 can always consider a Roth conversion. Next year everyone, regardless of their tax bracket, can convert or contribute to a Roth IRA. And because 2010 is also the last year of the Bush tax cuts, you can use the conversion as a way to avoid the coming tax tsunami in 2011. Make plans now to prepare for next year’s conversions.

14. Finally, a complex technique called “Roth segregation accounts” could earn your investments even more savings over the next two years. By segregating your Roth conversions in 2010, you can undo (or “recharacterize”) those that underperform and keep the winners. This strategy offers you 20 months to determine which accounts to keep. It’s as profitable as betting on the horse race after you know the winner.

Although just a small part of a larger comprehensive financial plan, savvy tax management requires professional assistance. Seek the guidance of a personal fee-only financial planner and certified public accountant (CPA), fiduciaries with a legal obligation to act in your best interests. The laws and ensuing complexities are changing annually, and as a result so is the optimum path.

Photo by Megan Marotta

Follow David John Marotta:

President, CFP®, AIF®, AAMS®

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.

2 Responses

  1. Linda Saltzburg

    Mr. Marotta,
    Why do you recommend small caps should be in a Roth rather than a regular IRA or a taxable account?

    • David John Marotta

      Great question Linda,

      With an IRA you have to pay tax on any capital gains at ordinary income tax rates when you take the growth out in retirement. With a taxable account you have to pay tax at capital gains rates when you sell the position. But with a Roth account any capital gains or interest or dividends grow tax free and owe no tax on account withdrawals.

      As a result, it is a tax management technique to put those equities liable to have the largest rate of growth in your Roth account to take advantage of the tax free growth. Large cap averages 10-12%, Mid cap 12-14% and small cap can average 14-16% return.

      Hence we recommend filling your Roth IRA with faster growing equities such as small cap first.