Our U.S. federal income tax law includes a number of built-in strategies available to reduce income tax liability. Your ability to legally reduce your own income tax bill depends on your level of understanding and utilization of the opportunities available in five key areas of financial planning:
- Source of income and the legal format of income-generating entities,
- Allowable accounting strategies,
- Use of real estate,
- Use of income deferral strategies, and
- Maximizing tax-free employee and executive benefits.
Adopting one or more of these tax strategies now will result in lower taxes next spring at tax filing time but many strategies need to be planned and executed well in advance. This listing below is meant to highlight the planning possibilities but is not intended to be a complete discussion of all of the details. Keep in mind that the effectiveness of many of these tax strategies is multiplied when they are used in combination.
For empty-nesters… it pays to downsize the home. Married couples can exclude up to $500,000 ($250,000 for single people) of gain on the sale of a home. That means possibly a half million dollars completely free of income tax. No other provision of the federal tax law is as generous. Considering the long term run-up in housing prices in many areas, this may be the time to consider cashing in and trading for a less expensive dwelling. There is no need to reinvest the gain in another house, so this strategy is perfect for empty-nesters who may be ready to downsize. See what the IRS has to say on this topic.
For self-employed individuals… Stretch tax-advantaged retirement plan deductions. Self-employed individuals can deduct up to 100% of current taxable income sometimes up to $260,000 for contributions to a private pension plan. Individuals who are close to retirement age, are self-employed, have income over $150,000 and work in a small business without many employees typically have the greatest opportunity to shelter earnings from taxes using this strategy. See this article about setting up your own pension plan. Plan documents must be on place in the year that the deduction is to be taken but the investment may be made in the following year prior to tax return filing. Self-employed individuals at incomes less than that amount are more likely to benefit from a Simplified Employee Pension, Health Savings Account and other similar options. Any of these options can be started quickly and at minimal cost.
For small businesses… Immediately deduct up to $500,000 for the cost of certain types of capital asset purchased rather than deduct the cost over time as is normally required. This break was nicknamed the “Range Rover write-off” when it was first introduced. The maximum allowed write-off was scheduled to be reduced to $25,000 for 2014 without the “tax extender” laws but is now restored to the full $500,000.1 The tax benefit is magnified when you finance a purchase and have not actually yet made cash payments. The IRS rules are commonly discussed under the term “Section 179“.
For employees… Receive tax-free reimbursement of out-of-pocket health care expenses. Use a Health Savings Account (HSA) if you are self-employed or use a Health Reimbursement Arrangement2 (HRA) for an employee. For 2014 the plan must be integrated with qualifying health insurance. Read more about HRAs here.
For lower income wage earners… Long term capital gains are now completely tax free as long as your total taxable income keeps you below the 15% tax bracket threshold. This tax break is based on the lower “taxable income” not the higher “adjusted gross income” amount so that more people actually qualify for this tax break. Taxable income is typically about $10,000 lower than adjusted gross income for single filers (or about $20,000 lower for married filers). That means, for example, a married couple living on one income of $50,000 sells something that they have owned for more than a year and make a $25,000 gain. The entire $25,000 gain is tax free. Also, a separate tax credit is available for low income individuals who make retirement plan contributions. The federal government effectively matches 50% of your deposit with a tax credit. Of course, the problem is that low income people do not have money to make retirement plan contributions. But parents could make a gift of IRA deposits to their children, for example, to effectively earn an immediate 50% return on their investment. Combining these strategies is even more effective: selling a capital gain asset tax-free and putting the proceeds into a tax-deductible retirement contribution and then getting an additional matching tax credit is an amazingly effective tax strategy. The problem, of course, is that most low income people do not have room in their budget for these types of transactions.
Need a personalized strategy to save taxes? Request a tax planning consultation to develop a customized list of possible strategies. This tax planning service is based on your last year’s tax return and adjusted for the changes that you expect for the coming year. The results are presented both in a written report and a brief personal consultation. The cost of this service is included in the basic concierge advisory package at wealthmanagement.us.com. It could be your smartest financial move of the year! Just call 800-609-0683 or send a brief message of introduction to request a personal tax analysis and I will respond on the same business day.
For investors… eliminate taxable dividends and short term capital gains. Mutual funds held outside of a retirement plan are not tax-efficient for most investors. Exchange-traded funds, on the other hand eliminate all of the unwanted taxable distributions and put tax control in the hands of the investor.
Use a deferred compensation plan. Despite recent tightening of rules for stock options and deferred compensation plans using corporate-owned life insurance, it is still easy to defer income using an employee benefit plan in other ways.
Take advantage of cash value life Insurance. Life insurance remains as the best tax shelter available to everybody. All investment gains can be borrowed from the policy tax free and the death benefits are also tax free to your named beneficiary. No other financial vehicles offer this generous tax treatment. If tax shelter is the goal then it is important to pay the maximum premium allowed into your policy to maximize the tax benefits (paying the minimum required premium is a dangerous financial strategy even aside from tax planning). US taxpayers should use a domestic life insurance company since the IRS is now cracking down on insurance used to move assets outside the country.
Take advantage of non-cash tax deduction for real estate depreciation. If you have rental properties, you may write off part of the purchase price and fix-up costs up to $25,000 per year even if most of the purchase price was borrowed.
Use asset-based mortgages. These loans make it easy for affluent individuals to finance 100% of the cost of a new real estate purchase. The interest is deductible and at today’ s low interest rates.3
The best tax strategy for your unique situation might not be included on this list but typically can be developed though a tax planning discussion either in person or by telephone. Please call to schedule a time to discuss tax planning ideas.
Before committing to any tax strategy, complete a pro forma tax return (future hypothetical tax return) to test the strategies for your unique situation. Pay special attention to income based phase-outs and the alternate minimum tax.
1 The maximum deduction allowed under Section 179 has varied over time with changing tax laws. It increased to $500,000 and then was scheduled to be reduced to $25,000 for 2014 without the “tax extenders” bill that was recently passed by Congress.
2 HRAs changed in 2014 under the rules for the Affordable Care Act but the same tax benefit will be available under a revised form called a “Limited Purpose HRA”. See www.freedombenefits.org for more on starting one of these plans for a small business. The cost for professional assistance with set up of a HRA is now included in the concierge advisory service offered at wealthmanagement.us.com.
3 Changes to mortgage banking regulations make these loans unavailable to most working-class Americans for residential real estate but in 2015 these loans have been re-introduced for commercial real estate.