After a flurry of activity leading up to tax day each year, many people want to put taxes out of sight and mind. Instead, a better course of action is to take proactive steps and reduce your tax bill going forward.
Pro Tip: Stop waiting for tax reform, and give yourself a “tax cut” by taking proactive steps to reduce your tax bill this year.
Why now?
Because many of the things you can do to reduce taxes need to occur during the year, rather than after. And having recently filed your return, you’ll have a good memory of what went into your return.
Recently, I shared key tips with Jo Constantz from Bloomberg on how you can reduce your tax bill, and I’ve included my full thoughts below. Here are some key tips to reduce your taxes:
Bunching charitable donations
If you consistently give to charities and your income was higher than normal, consider donating what you might have normally given over the next several years in a single payment while you’re in a higher than normal tax bracket. Notably, the point isn’t to change your habits for charitable giving, but to concentrate them when you’ll achieve the highest tax relief.
Create a Donor Advised Fund
Another related way we help clients is to create a Donor Advised Fund. This allows you to make a charitable donation during a high tax year, and then grow what you’ve contributed until a later date of your choosing when you will distribute funds to a charity of your choice. This tends to work well when someone has received a windfall and has decided to donate a certain amount, but needs time to consider which charitable cause(s) should receive their gift.
Max out 401(k) contributions
At a bare minimum, you should always be sure that you are contributing what is required to receive the full amount that your employer will match. If you’re married, and can afford to do so, be sure that both spouses contribute the maximum amount to their 401(k). Why mention this?
If you and your spouse have combined your finances, your money is (mostly) in one pot, so to speak. However, spousal incomes are never identical, so the percentage of wages contributed may vary dramatically. As an example, if contributing 5% of wages allowed one spouse to fully contribute while the other did not, you’d be missing out on being responsible in saving for retirement, as well as deferring taxes until retirement, when most people are in a lower tax bracket.
If you changed jobs
If you’ve changed jobs make sure that contributions under both plans in which you’ve participated do not exceed annual limits. For 2023, 401(k) contribution limits are $22,500 per person, with a $7,500 allowed catch-up contribution ($30,000 total) if you’re age 50 or older.
When people change jobs, their salary is certain to change, so the percentage of wages contributed to hit the maximum will change, too. Also, while plans will typically stop contributing wages once you’ve hit the annual limit, they won’t know how much you contributed to your old 401(k). This is a consistent problem for people that contribute the maximum amount, and those that hit the limit early into the year.
Document everything
One of the easiest mistakes to avoid is failing to document deductions you take. The last thing you want to run into is losing a deduction because you don’t have the paperwork to prove it.
Most expenses tend to be paid on debit or credit cards, so the more likely problem with failing to keep things organized is spending large amounts of time looking through receipts and card statements. If you’ve donated physical items during a spring cleaning, however, you’ll need to get a paper receipt.
Consider tax loss harvesting
Tax loss harvesting is another way that you can potentially reduce your tax bill, but successfully reaping its benefits does require following complicated rules so that any realized losses are not disallowed.
Also be sure that realizing losses doesn’t lead to a portfolio you didn’t actually intend to own when you reinvest funds elsewhere, or that you might be compelled to move back to the original investment once it’s allowable to do so while realizing a short-term gain on the new investment. Gains are good, but if you harvest a loss and later offset that with a short-term gain, it may not actually be helpful.
Track employer stock closely
If you receive stock options, restricted stock units (RSU), or other forms of stock from your job, make sure that any taxable events are closely monitored. This includes a broader array of actions that many people assume, and these issues are rampant among tech executives, and also biotech executives.
Common mistakes include not knowing that exercising stock options (without even selling them) can lead to a large tax bill (ordinary income tax, or AMT), or withholding the wrong amount of taxes when RSUs vest. And if your company is private, it’s unlikely you can sell any of that stock to cover a tax bill, either.
In most cases, the worst part is what people are forced to do in order to cover the cost of a large, unexpected tax, such as selling other investments at a loss. If taking action on your employer stock might push you into a much higher tax bracket, it might make sense to spread the taxable event over more than one year.
Don’t be reckless
Regular state income taxes differ greatly, and in cases where you had a large taxable event, or there was a big change in state taxes don’t many any rash decisions.
Also, don’t make big changes just because of news that a potential tax change is being discussed. Changes in taxes are always being discussed, so be careful about making a decision with permanent consequences, because they may prove to be transient.
If you’re looking to reduce your tax bill for 2023, it may be worth considering each of those which are applicable to you. In many cases, we work closely with our clients’ tax professionals to make sure they are achieving the best possible outcome.
To learn more about how we can help you with each of these, contact Paceline.
Read the full article on Blomberg here.
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.