There is an old saying that claims, “It’s not how much you make that’s the most important, but how much you keep.” Uncle Sam does his best to take at least a portion of everything we make. It is up to us to understand tax laws and retain as much as possible.
Tax planning is different from investing in that we have known information at the time we do it. We know exactly what the tax laws are in 2020. Making 8% and losing 1% to taxes is better than making 10% and losing 3% to taxes, yet many people fail to make that connection.
There are three smart tax planning strategies that federal retirees can use to preserve their nest egg and pass on more to the next generation. Before getting into these three different strategies, please understand that it is important to first determine where you fall in the tax brackets.
- What is your taxable income?
- How much room is there until you are bumped into the next tax bracket?
- Which capital gains bracket are you in?
- What will your taxable income be next year?
Each of the questions above needs to be answered before attempting to take advantage of the strategies below.
Roth Conversions for Federal Employees
This strategy is one that I have talked about over and over again. Roth conversions are something that must be addressed every year if you want to minimize future taxes. Of course, this option won’t be advantageous for everyone, but, in the chance that it is, this strategy can save you thousands (or tens of thousands) in taxes over your lifetime.
Here is an example.
Joe and Mary retired in 2019. Their annual leave check was paid out in January and they had a significant amount in savings. In 2020, they don’t expect to take any distributions from retirement accounts because of their high savings balance and annual leave checks.
Even with their annual leave, their taxable income will be significantly lower than it has been in previous years. Their taxable income will be approximately $40,000 after taking the standard deduction.
Joe and Mary plan to convert a minimum of $40,000 in 2020 in order to fill up the 12% tax bracket. In future years they expect to be in the 22% tax bracket. If they happen to go over the into the 22% tax bracket (when doing their conversion), they will only pay 22% tax on the portion above $80,250.
In this scenario, they will owe 12% taxes on the $40,000 versus 22% or more that is expected in the coming years.
This is a prime example of how important it is to evaluate what your tax rate is this year versus next year and subsequent years. If it’s lower this year than it will be in the future, then a conversion makes sense. If it’s higher this year, then a conversion probably isn’t a good fit.
Minimizing your taxes isn’t the only reason to do a conversion. Roth conversions are a great estate planning tool, as well.
Moving money from a traditional IRA to a Roth can eliminate future Required Minimum Distributions (RMDs) as well as maximize what is passed on to your beneficiaries. There are no forced distributions from Roth IRAs, and they pass on to beneficiaries income tax free. Additionally, beneficiaries can leave assets in the Roth for up to 10 years before withdrawing funds—helping to spread out their income tax free compounding over a longer period of time.
Please note: conversions can’t be done within TSP. Assets from the TSP must be transferred to an IRA and then converted to a Roth IRA.
Qualified Charitable Distributions (QCD)
If there is an underutilized tax strategy for the middle class, this is it. A QCD is an otherwise taxable distribution from an IRA that is paid directly to a charity. Keep in mind, an individual must be over the age of 701/2 to be eligible to make a QCD.
In the past, most families could itemize their taxes and receive a deduction for charitable giving. However, the passing of the Tax Cut and Jobs Act (TJCA) changed a number of things that make it harder to itemize. In other words, most federal employees, and more specifically most federal retirees, now take the standard deduction. If you take the standard deduction, then you don’t receive a tax benefit for charitable giving.
A qualified charitable distribution allows a person to benefit from their charitable giving without itemizing. A distribution that would otherwise be taxable is not taxable as long as it goes directly to the charity. There is no tax deduction, but there are no taxes to be paid on the distribution, either.
A QCD can also take the place of Required Minimum Distributions that start at age 72. For people being forced to take distributions because you have reached age 72, this is a great way to reduce taxes on those forced RMDs.
Please note: According to TSP, QCDs cannot be done with TSP. Money would have to be transferred to an IRA where a QCD could be done.
Tax-Loss and Tax-Gains Harvesting
Tax-loss harvesting involves looking at your taxable investments and selling off the losing ones each year. Selling a losing position allows you to deduct up to $3,000 from your income in that year as well as carry forward any remaining losses in the years to come. Losses can also be used to offset gains.
The proceeds from the sale of your investment can be invested in the same security 30 days after the sale, or invested immediately in a similar security but not “substantially identical.”
Tax-gains harvesting would also be a good fit for the scenario provided with Joe and Mary above. If Joe and Mary stay in the 12% tax bracket, then they would pay a tax of 0% on long term capital gains. Even though it may be a position you prefer not to sell, it could be beneficial. You could sell the position and immediately buy it back to increase your basis.
Again, tax-loss and tax-gains harvesting are for taxable accounts only.
These are three of the most common tax planning strategies I have implemented with federal employees. Please don’t let another year go by without considering the taxes you pay and the potential ways to reduce your tax bill today and in future years. Saving money to build your wealth is the hard part, doing your best to preserve it is the fun part!