One of the most common questions our investment clients ask us is: “How can we reduce our taxes?” The answer to this question can seem more complicated than it needs to be. The frustration of paying taxes doesn’t mean you should quit making money. In fact, the federal tax code provides legal ways to reduce your taxes. If you can take advantage of such reductions, go for it! As a point of reference, this article is based on the potential tax situation of married taxpayers who are not self-employed, with a taxable income above $450,000 per year. I’m going to suggest some basic ways that these taxpayers could reduce their current and future income tax bills. Although the rates and some of the calculations are tied to those in the highest marginal tax bracket, the tax-saving ideas could be helpful to taxpayers at any level. As the calendar turned to 2013, Washington, D.C. gave us a party bag of tax gifts. We got a shiny new top marginal income tax bracket of 39.6 percent. And if that wasn’t enough, we got matching top tax brackets for short-term capital gains and interest income. But wait, there’s more! You may also be the proud owner of a 20 percent tax rate on long-term capital gains and qualified dividends. Plus, if you call now, you can lock in a 3.8 percent Medicare surcharge and a 0.9 percent Medicare payroll tax. It was a great New Year’s party – for the U.S. Treasury Department. Now. What can you do to reduce the income taxes you pay each year? Simply put, plan well. Unfortunately, there’s not much you can do about the income taxes you pay on your W-2 earnings. Aside from qualified and non-qualified plans established by your employer (qualified plans are common; non-qualified plans are less common), you will pay ordinary income taxes on your earnings. So let’s look at the basic ways to reduce the taxes you pay each year. • Tax deferral: You should maximize your 401(k) contribution, if eligible. The limit for 2013 is $17,500 ($23,000 if you are over age 50). This could reduce your current tax liability by almost $7,000 (about $9,000 if you are over age 50). Not only could this reduce the amount of taxes you pay this year, it will also defer the taxes on your earnings until you begin taking distributions in the future. If you are fortunate enough to have a Roth 401(k) option through your employer, you may choose to contribute to it instead of a traditional 401(k). A Roth 401(k) will not reduce your taxable income in the year of your contribution but your annual earnings will be tax-free. Another tax deferral method is a non-deductible contribution to an IRA. The limit is $5,500 ($6,500 if you are over age 50). You may even be able to provide a contribution of the same amount for your spouse. These contributions won’t help you in the year you make them, but will help each year thereafter because you’re deferring the income tax due on the earnings. Again, no taxes are due until you withdraw the funds. A conversion of the non-deductible IRA contribution to a Roth IRA is also available for some. This will actually eliminate the taxes on the earnings. A third method for deferring taxes is through the use of a basic annuity product. An investment in an annuity product provides deferral benefits similar to a non-deductible IRA contribution. No taxes are due on earnings until you pull out the funds, and you can make contributions much larger than the IRA limits. If you are looking only for tax deferral, seek out a lower-cost annuity designed for tax deferral. You don’t necessarily need all of the other expensive features available from the annuity. • Lower tax rate options or tax-free options: The tax code incentivizes long-term investing (greater than one year) by providing reduced tax rates on long-term capital gains and qualified dividends from stocks. Each dollar of dividends or gains is taxed at a rate of 20 percent (plus, you may be subject to the new Net Investment Income Tax of 3.8 percent). Any tax rate below that of the maximum 39.6 percent reduces your effective tax rate on your total income. This is a tax-rate reduction of nearly 50 percent on these types of earnings. Additionally, tax-free municipal bonds are a great source of tax-free income for most individuals. The solutions listed in this article are designed to help you reduce your overall tax burden. As your investment income continues to grow as a percentage of your overall income, your effective tax rate will drop. Any reduction in taxes is worth the effort. Each of the ideas I’ve presented has certain rules and may not apply to everyone. Please work with a qualified investment adviser to receive advice based on your individual situation.
Marc Sloter is a certified financial planner. He is not a taxpreparer and his suggestions on tax savings should be considered accordingly. He is an investment adviser with WWK Wealth Advisors.