Today, we’re talking…taxes!
Specifically, we’re sharing our top three tax saving tips that tend to fly under the radar.
These little-known tax tips will teach you how to put more money in your pocket and less in Uncle Sam’s.
It’s only September, which may seem early to start talking about taxes. Most people don’t start thinking about tax planning until year-end.
But the end of the year is busy. And hectic. And important things like taxes don’t get your attention during busy, hectic times. So, we are tackling it now.
With that in mind, we’ve got our top three little-known tax saving tips. These are strategies that can save you a lot of money in 2018 and beyond:
- Donor-advised tax funds (DAFs)
- Mega back-door Roth IRA
- Asset Location
How to Listen to Today’s Episode
Episode Links & Resources:
- 👉 Get Your One-Time Retirement Plan
- How Tech Billionaires Hack Their Taxes With a Philanthropic Loophole
- America’s Most Charitable Cities: San Diego tops the list
- Asset Location For Stocks In A Brokerage Account Versus IRA Depends On Time Horizon
- Traditional vs Roth: Breaking Down Retirement Accounts [SWSD Ep. 24]
- How to Lower Taxes in Retirement [Blog Post]
- What the Heck is a Mega Backdoor Roth
Episode Transcription
[fusebox_transcript]Top 3 Tax Saving Tips
1. Donor-advised tax funds (DAFs)
DAFs are a flexible way to contribute to charitable 501(c)3 organizations, and they’re our favorite tax tip because the tax benefits are twofold: You get to you get to claim the money you contribute as a charitable donation on your taxes; and if you donate appreciated stocks, you avoid capital gains taxes on those assets.
The way it works is this:
You give your assets to a sponsoring organization, such as Fidelity Charitable, Schwab Charitable, or Vanguard Charitable.
You take the charitable donation deduction for the year in which you donate.
And then the sponsoring organization makes contributions to charities you choose whenever you give the say-so.
Although a recent article in The New York Times highlighted the use of DAFs by tech billionaires, they really are available to anyone. The median account balance for Fidelity Charitable, which is the biggest of these sponsoring organizations, was just under $20,000 in 2017. DAFs are also very low-cost and simple to set up and use.
The one caveat is that DAFs will only have a tax benefit if you itemize your deductions. Standard deduction limits were increased for the 2018 tax year to $12,000 for individuals and $24,000 for married couples filing jointly. So if you don’t plan to itemize going forward, you’re not going to get the full benefit of a DAF.
Assuming you do plan to itemize, here’s an example of how a DAF might save you.
Let’s say my wife and I give $10,000 every year to the Labrador Retriever Foundation. I want a big, messy, dirty chocolate lab. She won’t let me have one, so instead, we just give a bunch of money to the Labrador Retriever Foundation every year.
But this year, we sold a rental property and our tax bill is going to be higher than usual. One way to lower it is to give more to the lab foundation – let’s say we need to give $30,000 to the foundation this year instead of the usual $10,000 to lower our tax bill.
I could just give that amount outright. But, a DAF gives me the flexibility to spread those donations out over three years so I can stick to my original schedule — or, I can request that $10,000 goes to the Labrador Retriever Foundation this year and next year I give to someone else. Or I can put off distributing those funds to anyone indefinitely. They can go to any 501(c)3 organization that I want at any time I want.
That’s the beauty of a donor-advised fund: It gives you tons of flexibility.
DAFs make the most sense for folks who donate appreciated securities. Say you’ve got a stock or fund that’s grown in value over a long period of time. You don’t want to pay capital gains tax, but you do want to support charitable giving. If you donate the appreciated security to the DAF, you don’t have to pay the capital gains tax.
2. Mega back-door Roth IRA
Unlike the donor-advised fund, this is a long-term tax saving strategy. Its goal is to allow people who can’t normally contribute to a Roth IRA to do so.
When it comes to retirement accounts, 401(k)’s are important, but you also want to put as much money as possible into a Roth IRA. That’s because as the money in a Roth grows, the gains are not taxed.
Let’s say you put $5,500 into a Roth IRA this year and it grows to $55,000 in 30 years. For the sake of this example, we’re just assuming you don’t contribute anything else. When you start to withdraw that money in 30 years, none of it will be taxed. You’ve already paid taxes on the $5,500 principal, but you never pay taxes on the $49,500 worth of gains. That’s why a Roth is such a great investment vehicle. A 401(k) will save you on your tax bill now, but you will have to pay taxes on the principal and the gains when you withdraw the money in retirement.
The other benefit of a Roth is that it’s not subject to required minimum distribution rules, meaning you’re not forced to take your money out at age 70 ½, like you are with a 401(k).
The thing is, some people make too much money to fund a Roth. According to IRS rules, for 2018, individuals making $135,000 or more can’t contribute to a Roth. A mega backdoor Roth gets around that limit.
How? First of all, you have to max out your 401(k) contribution for the year – so that’s $18,500 for an individual in 2018. If allowed by the plan, you can make after-tax contributions of up to $36,500, bringing the total for 2018 up to $55,000. In this example, let’s say there’s no employer match, so we’ve made $18,000 in after-tax contributions ourselves.
Next year, you can withdraw that $18,000 after-tax contribution amount – assuming your employer allows in-service non-hardship withdrawals – and put it directly into a traditional IRA. You can then convert that traditional IRA into a Roth IRA.
Note that you can only do this if your employer 401(k) account allows you to make in-service non-hardship withdrawals. You’ll need to contact your benefits department and ask for a summary plan description (SPD). It will tell you if after-tax contributions and in-service withdrawals are allowed.
3. Tax-friendly asset allocation strategy
This strategy works only for people who already have long-term investments in both taxable accounts (such as a regular brokerage account) and tax-favored retirement accounts (such as a 401(k) and/or a Roth IRA). And it assumes that you’re investing in stocks and bonds. Along with bonds you maybe have other coupon-paying investments such as real estate investment trusts (REITs) that, like bonds, generate regular cash flow that you have to pay taxes on every single year.
The income you receive from bond interest or from your REITs gets taxed at the highest income rate, which is 37% if you’re in the top income bracket. The income you receive from stock dividends and capital gains get taxed at only 20%.
A tax-friendly asset allocation strategy says to put bonds and REITs into a tax-deferred account like a 401(k). That way, you won’t pay taxes on your income from those funds until you retire, when you’ll supposedly be in a lower tax bracket.
If you’ve got stocks, you put those into your taxable account because your taxes on any dividends you receive in the tax year, plus any capital gains you realize, will be only 20% instead of 37%.
The third part of this strategy says to put investments that are going to grow the most into a Roth IRA. That’s usually the riskiest investments you have, which also tend to have the highest returns. That means small-cap stocks and emerging market stocks. Assuming those investments grow a lot, all of that growth is going to be tax-free.
Keep in mind, these are just rules of thumb. Your strategy may differ if your needs are different or you’ve got a different kind of portfolio diversification.
– Stay Wealthy
