Year after year, most people ‘leave money on the table’ by neglecting small actions they can take to reduce their tax bill.
This happens in spite of the fact that most actions require very little effort, and people hate paying taxes.
That’s why we created the Tax Cut Challenge.
It’s a list of 7 easily implemented actions you can take to reduce your tax bill for 2023.
Also, we’ve included common objections to taking action, and why that’s often not the best choice.
So, what’s the catch?
There is no catch, but there is a deadline.
To reduce your taxes for 2023, each of these must be completed before year end.
With the holiday season soon approaching, it’s a great time to identify which of these is relevant to your household and begin taking action.
1. TAX LOSS HARVESTING
Objection: Why bother with tax loss harvesting? I'm not sure if it's worth the effort.
Response: Tax loss harvesting can significantly lower your tax liability by offsetting capital gains with capital losses. Identifying investments that are priced below what you originally paid isn’t difficult, but it can be helpful for a professional to take a look, too.
Why? When an investment has lost money, the top priority is to earn back the loss, and that can come from that investment recovering, or from a gain invested in anything else.
Also, it’s important to understand wash-sale rules, which disallow losses if an investment is repurchased less than 30 days later. This encompasses ALL accounts that you own, not just the one where you harvested the loss.
Over the course of a 30-day waiting period, it’s also possible that markets may move, complicating your plans if you wanted to hold that money in cash until returning to what you were originally invested in. That’s why tax loss harvesting is simple in concept but can be more complicated in practice.
Annual Limit: There is no specific annual limit for tax loss harvesting, but it can help you in three different ways. They can offset capital gains in the current year, be rolled over for future use, and additionally can be used to offset up to $3,000 in ordinary income each year (i.e., salary).
2. 401(k) CONTRIBUTIONS
Objection: I'm already contributing to my 401(k). What's the point of contributing more?
Response: In addition to saving responsibly for retirement, contributing to a 401(k) delays income being taxed until retirement when (in nearly all cases) you will be in a lower tax bracket. Contribution limits have also jumped more than they normally do in recent years, as a result of inflation.
Also, if you regularly hit the maximum contribution and changed jobs this year, it’s important to be sure that you didn’t exceed contribution limits for the year. That’s because current and former employers don’t share data on your contributions.
So, to avoid a tax penalty, you’ll need to withdraw any excess contributed amount, plus any income earned on that money while it was invested.
Annual Limit: As of 2023, the annual contribution limit for a 401(k) is $22,500 for individuals under 50, and $30,000 for those aged 50 and older. These limits apply to contributions across all plans in which you participated this year.
3. TAX-FREE INVESTMENT INCOME
Objection: Tax-free investment income sounds great, but…. how do I do that?
Response: Municipal bonds can be a great addition to your portfolio, though they make the most sense for investors who are in a high tax bracket. In nominal terms, they tend to pay lower rates of interest compared to taxable investments, but on an after-tax basis they can be very attractive for people in higher tax brackets.
Even if you don’t take income from your portfolio to cover living expenses, investment income is new money that can be reinvested anywhere you like, on a recurring basis, towards whatever looks most attractive at that time.
4. BUNCHING CHARITABLE CONTRIBUTIONS
Objection: What is that? Is it worth the hassle?
Response: Bunching charitable contributions is the practice of donating what you normally might over the course of several years during a single year, when you happen to be in a higher-than-normal tax bracket.
This way, you’ll be taking deductions against your taxable income when you are in an abnormally high tax bracket and maximize the tax savings from your gift. By being more tax-efficient with your gift, you’re being rewarded for doing more of a good thing.
Annual Limit: There is no strict annual limit for charitable contributions, but you need to be mindful of the standard deduction, as not all households are best off by itemizing tax deductions.
5. OPENING A DONOR-ADVISED FUND
Objection: Why open a donor-advised fund when I can donate directly to charity?
Response: The reason for opening a donor-advised fund is similar to bunching charitable contributions (i.e., contributing a large amount in a single year, when you have a high tax bracket), but it provides some additional flexibility.
Specifically, it eliminates the burden of deciding where you plan to make your charitable gift, and it allows you to invest these funds and grow them until a future date of your choice when they can be distributed.
As a result, it provides tax-efficiency in the same way that bunching contributions does, but it removes the urgency to decide which causes will receive your gift.
This works especially well when your plans for charitable giving may be different from what you’ve done in the past or need to quickly complete your gift for tax purposes before year-end. This way, you’ll have more time to decide which causes to support with your gift.
6. STRATEGICALLY EXERCISING EMPLOYER STOCK OPTIONS (ISOs)
Objection: Managing employer stock options seems complicated. Why take a strategic approach to managing Incentive Stock Options (ISOs)?
Response: One of the big benefits of ISOs is that exercising your stock options starts the clock on the 12-month holding period until they can be taxed as long-term capital gains. The flipside of this is that if you do too much of it, exercising your stock options alone, without even selling any of them, can leave you saddled with a big tax bill (i.e., Alternative Minimum Tax, or AMT).
Additionally, because most people don’t have cash laying around for a large, unexpected tax bill (why would they?), many end up making non-economic investment decisions to cover taxes. Examples include unplanned withdrawals from 401(k) accounts (and paying a tax penalty, in addition to income taxes), or being forced to sell an investment at an inopportune time.
That’s why it’s important to have a strategy in place to find balance between trying to achieve the best tax treatment on employer stock options, carefully managing liquidity (how much cash you have on hand), and achieving good investment value (i.e., selling at the right price). And when people focus too closely on one of these factors, they tend to solve for one at the expense of both the others (or all three…).
7. STRATEGICALLY LIQUIDATING EMPLOYER STOCK
Objection: Why should I bother with the timing of selling employer stock? Why not just sell my employer stock when I need cash to pay for something else?
Response: Similar to what we’ve mentioned above with exercising stock options, it’s important to take a strategic approach to selling all forms of employer stock (including stock options, RSUs, and employer stock purchase plans).
Many people resort to ‘raiding the cookie jar’ by selling off portions of their stock whenever life dictates that they have another use for that money. This is not a strategy but a symptom of the absence of one.
The problem here is that if you are simply selling your stock when you need cash, it isn’t optimizing for selling at an attractive price, or for the purpose of reducing taxes either.
Basically, this treats money sitting in employer stock as if it were a savings account, when there are very big differences. Cash sitting in a bank account does not fluctuate in value, and you can access it any time you want.
Employer stock, however, fluctuates constantly based upon stock price movements, and employees at a public company have only a limited window of time to trade their shares each quarter.
That’s why strategically liquidating employer stock can help you manage capital gains and potentially reduce your overall tax liability. Equally important, you’ll have a plan to do so while selling at an attractive price.
PUTTING IT ALL TOGETHER
Reducing your tax bill is not only possible but also essential for building wealth and securing your financial future. By implementing these tax-saving strategies and debunking common objections to taking action, you can take control of your finances and pay less in taxes.
Contact Paceline to discuss how you can achieve any of these before year end.
This blog was written by Jeremy Bohne, Principal & Founder of Paceline Wealth Management. Paceline is a fee-only investment advisor serving clients in the Boston area, and on a remote basis throughout the country. Paceline specializes in helping tech and biotech executives, physicians, and those seeking financial planning services.