Taxes

Taxes are a major part of your finances and is intertwined in almost every financial decision you make. Below are some items to think about related to taxes. As always, you should consult your CPA, tax preparer, financial advisor, or financial planner before taking action on things that will affect your taxes. 

Tax-Loss Harvesting:

• When the market is down and/or near the end of the year (November or December), you should check the gain/loss of investments in your taxable accounts (this isn't relevent for retirement accounts since taxes are deferred or never taken). If there are positions with losses, you could sell those postions and then invest in similar (but not identical) positions and harvest the losses. After 31 days, you could repurchase the initial securities you sold and keep the losses you harvested (otherwise it is a wash sale). 

Contributions to Retirement Accounts:

• Contributions to IRA/Roth IRA (these not accounts through your employer) - if you have earned income, you can contribute to a traditional IRA or Roth IRA each year. 

  • Contributions to traditional IRAs can be with pre-tax dollars (meaning they lower your taxable income in the year they are earned) or after-tax dollars (meaning you already paid income taxes on them). In both cases, the assets will grow without paying taxes on them.  Eventually when you do take the assets out of the account, you do pay ordinary income tax rates on them. If you contribute pre-tax dollars, then 100% of the distributions from the account are taxable when taken out if you are at least 59.5 years old. If you are younger than 59.5 when you take the funds out, then there will be a penalty on them. If you contribute after-tax dollars, then you aren't taxed on the amount you had already contributed to the account, but are taxed on the growth of those investments. You want to make sure you account for what contributions are pre-tax and what are after-tax. 

  • Contributions to Roth IRAs are with after-tax dollars (meaning you already paid income tax on them before you received them) and the growth inside the Roth IRA is tax-free as long as you wait until you are at least 59.5 to take the funds out and have had them in the account for at least 5 years. 

• Contributions to employer retirement accounts - if you have an employer that offers an employer match on part of your 401k or 403b account, you should save at least that amount. Usually, retirement plan accounts will have the ability to have pre-tax portions, roth portions, and after-tax portions.

  • Pre-Tax - contributions lower taxable income in the year earned and you aren't taxed on the contributions or growth until assets are taken out of the account in retirement.

  • After-Tax - contributions do not lower taxable income in the year earned and are taxed on that year. You aren't taxed on the growth until assets are taken out of the account in retirement.

  • Roth - contributions do not lower taxable income in the year earned and are taxed on that year. You aren't ever taxed on the contributions or growth if you wait until at least age 59.5 to take them out. 

Contributions to Health Savings Account:

• If you use a high deductible health plan for your medical coverage, then you are able to contribute to a Health Savings Account (HSA). If you are able to contribute to one and can afford to save, you should. A HSA can be used to cover qualified medical expenses (make sure to save receipts for medical expenses). The biggest benefits of an HSA are:

  1. The contributions lower your taxable income the year earned if taken directly from payroll. This means you pay less in taxes taht year. 

  2. The assets in the HSA can be invested and grow tax-free for years until you use them. If you continue to pay medical expenses today and in the near-term future, you can let the assets in the HSA grow for decades to be used down the road in retirement. 

  3. If you don't end up needing the assets for medical expenses in retirement, you can use them to pay other bills and just pay ordinary income tax rates on them, just like you would have if they were in an IRA or 401k account. 

  4. Bonus - if your HSA has been established at the time of medical expenses and you pay out of pocket with regular funds, but want to be reimbursed by the HSA later in time, just hold onto your receipt and you can then take the HSA distribution tax-free. 

Roth Conversions:

• In years where your income is lower than normal, it might be a good idea to look at a roth conversion. This is where you transfer assets in a pre-tax account (Traditional IRA, 401k, 403b, Rollover IRA, etc.) into a Roth account (Roth IRA, Roth 401k, Roth 403b, etc.). You pay income taxes on the gain between the contributions in the pre-tax account and the current value of the pre-tax account that you are transferring over. It is essentially treated as income in the year of the conversion. This can be good if the tax rate you pay today on the conversion is lower than the tax rate you would have paid on taking funds out of the pre-tax account down the road. 

Charitable Gifting to DAF:

• If you are charitably inclined and want to bunch a large amount of donations in one tax year to help maximize the tax deduction (this can be useful if you typically take the standard deduction, but take the itemized dedution the year you do a large amount of charitable gifting), you could contribute investments that have appreciated and have large gains into a Donor Advised Fund (DAF). You can open a DAF at Schwab, Fidelity, or other providers and they have low-cost and good investment options to choose from. The investments in the DAF can be used to donate this year to other charities or any year in the future. You create a good tax savings opportunity the year given, but can enjoy the benefit of giving to multiple charities for years to come potentially. 

Once you are 70.5 years old:

• You can take Qualified Charitable Distributions (QCDs) from your IRA once you are at least age 70.5. This allows you to give away assets to charitites that could use the resources, help you satisify potential RMDs (most likely RMDs won't start until you are 73 or 75), and lower your tax liability. 

There are multiple types of taxes that most of us have to pay. Your tax return you file each year only typically deals with the first 2 listed below. They can include the following:

1. Federal Income Tax

   • Ordinary Income Tax

   • Qualified Dividend/Long-term Capital Gains Tax (lesser % than Ordinary Income Tax)

2. State Income Tax

3. Local Income Tax

4. Property Tax

5. Sales Tax

6. Payroll Tax (FICA)

7. Self-Employment Tax (Double FICA)

8. Medicare Tax

9. Net Investment Income Tax

10. Alternative Minimum Tax (AMT) 

Calculation of Federal Income Tax:

• There are multiple different income numbers in a tax return:

  • Gross Income - this is all of your income (wages, taxable interest, ordinary dividends, taxable IRA distributions, taxable social security, short-term capital gains, business income (schedule C), rental income (schedule E), partnership income (schedule E), S-Corp income (schedule E), etc.) 

  • Adjusted Gross Income (AGI) - this is your gross income less your "above the line" deductions. These deductions typically include, but are not limited to, the following:

    • pre-tax IRA contributions, HSA contributions, self-employment tax, self-employed health insurance premiums, etc. 

  • Taxable Income - this is your AGI less the standard deduction or itemized deductions(the biggest items that are typically included in itemzied deductions include, but are not limited to: medical expenses, mortgage interest, property and sales taxes, charitable giving). If you own your own business, then QBI can be deducted from your AGI as well.