Seven Tax Ideas

That you CPA STILL hasn’t mentioned?

As many people learned the hard way this year, tax rates have gone up. The American Taxpayer Relief Act was passed in late 2012, and became effective for the 2013 tax year. As a result most people were not aware of how this impacted them until they sat down and reviewed their 2013 tax returns. Now they are painfully aware that tax rates have gone up and they want to know how to reduce their tax bill.

Chess board representing strategic tax planning in Danville, CA

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While this is a question that has to be addressed on a specific client-by-client basis (which of course we are happy to do), here are a few general concepts worth learning about:

  1. Profit Sharing Plans– Line 7 on your tax return shows wages. This number is net of any pre-tax retirement plan through your work such as a 401k or profit sharing plan. If you are a business owner, look into a profit-sharing plan. This is a way to increase your pre-tax savings and thus reduce your taxable income.
  2. Tax-free interest– Line 8a of your tax return shows taxable interest, line 8b shows tax-exempt interest. No real surprise here, tax-exempt is better than taxable! When you think of taxable, think interest on a CD. When you think tax-exempt, think municipal bonds. If interest is a big component of your income, consider shifting from taxable to tax-free investments.
  3. Qualified vs. Ordinary dividends– Ordinary dividends are taxed at your normal tax rate whereas qualified dividends are taxed at a low 15% rate. The rules on what makes a dividend qualified vs. ordinary are beyond the scope of this article, but this is an area where you could make a few changes to your investment mix and reap a tax savings.
  4. Capital Gains– While your specific capital gains tax rate depends on several factors, what is important to note here is that there is some tax planning that can be done to avoid or defer capital gains. Things like Donor Advised Funds (see next item), Charitable Remainder Trusts, 1031 exchanges, and even gifting appreciating assets to heirs in lower tax brackets are all ways to reduce or defer these taxes.
  5. Donor Advised Funds (DAF)– A DAF is a way for an investor to receive an immediate tax benefit from the amount they want to donate, but then dole out those gifts to charity over time. For example, let’s say you normally give $10K/year to your favorite charity. And let’s also say your tax bracket is higher now than it will be in the future. You could set up a DAF, throw $100K in there and get a charitable deduction on the full $100K now. You could then take $10K/yr out of that $100K and send it to your favorite charity. So the timing of the gifts to charity hasn’t changed, but the timing of the tax deduction has. I am simplifying here so make sure to talk to your financial advisor or CPA before setting up a DAF, but simply being aware of their existence is a start as these concepts could really save you on taxes.
  6. Cash Value Life Insurance– Most people know that life insurance provides a tax-free death benefit to heirs, and that’s about all they know when it comes to insurance. Cash value life insurance, when designed properly, can also create a tax-free savings account and isn’t restricted to the same limits on contributions as an IRA or a 401k plan. Next month we will focus exclusively on this subject so for now just keep the idea in mind as something worth knowing about.
  7. Non-Qualified Annuities– Nonqualified annuities grow tax-deferred, which means you won’t receive a 1099 each year showing tax on earnings like you do with a CD or mutual fund. Eventually the tax gets paid but deferring that tax can go a long way in terms of compound growth over time.

The less you pay to Uncle Sam the more you can save and invest

These are just 7 ideas but there are many more just like this. Our tax code is complicated and your CPA probably doesn’t spend enough time with you to really understand how each one of these items could benefit you! That is part of the reason that Wealth Managers and Financial Planners exist, because the less you pay to Uncle Sam the more you can save and invest.