There’s a lot to think about when nearing retirement. Do I have enough money saved? Do I know where I want to live? Do I know when I want to start collecting Social Security? What are RMDs?
One thing that might not be on your mind? Taxes.
We’re so used to dealing with taxes that they tend to become background noise to our financial lives. But did you know there are specific ways to use tax plans that can help you if you’re nearing retirement?
What is Tax Planning?
Tax planning differs from filing your tax return, and it’s a strategic way to reduce your tax liability.
The main difference between tax planning and tax preparing is that, as the name implies, tax planning is a proactive effort. When you curate your tax return, you’re organizing items that typically have already taken place, so you’re limited in how strategic you can be.
Tax planning lets you minimize your future tax footprint instead of making the most of what you’ve already done throughout the year.
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What Tax Planning Can Do for People Nearing Retirement
A productive way to ease into a retirement transition is to take a bird’s eye view of your finances. Being in the dark about your assets can be stressful! That’s why every good financial plan has a tax plan that works in tandem for clarity and support.
The idea behind tax planning is simple. The more effort you put into your tax plan, the more control you have over your total tax liability. In addition, a thorough tax plan can help you avoid potentially expensive mistakes – like missing your required minimum distribution (RMD) requirement or improper tax withholding as a small business owner. All things you don’t want to worry about or deal with in retirement!
Let’s explore some tax planning strategies that could be of value for high earners nearing retirement.
Making the Most of Your Tax-Savvy Accounts
A large portion of tax planning ensures you’re maximizing your tax-efficient accounts. Most commonly, Health Savings Accounts (HSAs), 401(k)s, IRAs, and Roth accounts.
Health Savings Accounts
Did you know that Health Savings Accounts (HSAs) are triple tax-advantaged?
- Contributions made to an HSA are tax deductible.
- The money within your HSA grows tax free.
- Withdrawals from an HSA are tax-free as long as they are used for qualifying medical expenses.
Needless to say, if you aren’t taking advantage of your HSA, you’re likely missing out on both tax planning and tax preparing strategies which are highly successful. HSAs can also be an effective retirement savings tool because the money never goes away, unlike a Flexible Spending Account (FSA).
As an added bonus, if you withdraw from your HSA after age 65, the withdrawals are tax-free and can be used for any purpose – not just qualifying medical expenses. In short, it pays to plan.
HSAs are similar to other types of retirement savings accounts because they have contribution limits. In 2023, the contribution limits are $3,850 for single filers and $7,750 for joint filers. However, those aged 55 and older get an extra $1,000 added to their limit for catch-ups.
It’s important to note that HSAs are only available to those with High Deductible Healthcare Plans (HDHPs), so eligibility for an HSA can vary.
There’s a reason 401(k)s are a popular investment vehicle. These employer-sponsored retirement savings accounts are easy to use and tax efficient.
Other benefits of 401(k)s include employer matches, high contribution limits, and tax breaks.
Contributions are made on a pre-tax basis, which means you can deduct contributions in the year that you make them, lowering your taxable income for the year. In addition, the account funds grow on a tax-deferred basis, and you don’t have to pay tax on capital gains until withdrawal.
In 2023, the contribution limit for a 401(k) is $22,500 or, if you’re 50 or older, $30,000.
Individual Retirement Accounts (IRAs) & Roth Accounts
IRAs are primarily designed for self-employed people without access to a 401(k). Many types of IRAs exist, including traditional, Roth, Simplified Employee Pension (SEP), and Savings Incentive Match Plans for Employees (SIMPLE).
When you open an IRA, you can choose your funds’ investments, including stocks, bonds, exchange-traded funds (ETFs), or mutual funds, to name a few.
For 2023, the annual contribution limit for an IRA is $6,500, or $7,500 if you’re age 50 or older.
There is also a retirement savings option called a Roth IRA that you can contribute to after-tax. Your contributions grow tax-free, and withdrawals are tax-free as long as you’re over 59 ½ years old.
Strategic Charitable Giving
If charitable giving is part of your financial plan, there are mindful tax planning strategies that can help you maximize both charitable giving and tax savings alike.
This refers to grouping gifts you intend to give over multiple years. The benefit is this: if you had a year with a higher income than expected, you give $20,000 and then itemize your deductions.
Even if you don’t give to charity the following year, you can still take the standard deduction because you had increased tax savings the previous year.
Remember, the standard deduction in 2023 is $13,850 for single filers and $27,700 for couples. If your aggregate itemized deductions (not including the charitable deduction) are below the standard deduction, that would be the time to consider bunching your gifts to give more while saving on taxes.
Donor Advised Fund (DAF)
Another option is giving through a donor-advised fund (DAF). This is essentially a charitable investment account that lets you give directly to a qualified charity and receive an immediate tax deduction.
DAFs are helpful if you want to maximize your charitable deductions but aren’t sure where or to whom you want to give. For example, let’s say you have an exceptionally high income year. You can allocate funds toward your DAF to avoid higher taxes, then when you decide which charity you’d like to give to, the funds will be there to donate.
However, do note that giving to a DAF is irrevocable, so once your funds are in the DAF, you cannot take them out again.
Tax Loss Harvesting
This is a strategy that sells securities at a loss to balance the amount of capital gains tax owed from selling other profitable assets. The goal is to reduce overall taxes on your securities.
For example, if you have a stock growth worth $3,000 and another that has depreciated and is worth $2,000, you could offset the two and only be responsible for $1,000 of the capital gains.
Remember, you can only offset $3,000 maximum of ordinary income in a tax year. However, if your losses exceed that amount, you can roll them into the following tax year.
Here’s another example. Let’s say you have an annual capital gain of $15,000 and a capital loss of $18,000; you could cancel out the capital gain and deduct the remaining $3,000 from your taxable income. Anything more significant than an $18,000 loss could be moved to the next tax year.
There are rules to be aware of regarding tax loss harvesting. Long-term losses must offset long-term gains, assets you’ve owned for at least one year. The same is true for short-term losses and gains.
Also, the ‘wash sale rule’ states that if you sell an asset at a loss and buy a similar or identical asset within 30 days, you aren’t allowed to realize the loss for tax purposes. Your tax professional and financial advisor can be helpful when implementing these strategies.
Use All Available Tax Deductions and Credits
Let’s start with above-the-line deductions. These are used to reduce your adjusted gross income (AGI) whether you decide to itemize or take the standard deduction.
Since your AGI determines eligibility for other credits or deductions, reducing your AGI through above-the-line deductions can be highly beneficial – especially for high earners that may otherwise be ineligible for certain benefits.
Some common types of above-the-line deductions include:
- Self-Employment Tax – You can deduct half this tax that your employer would have paid if you were employed by someone other than yourself.
- Alimony – Those divorced before January 1, 2019, may be able to deduct alimony payments from their taxable income.
- Student Loan Interest – The IRS lets you annually deduct up to $2,500 in student loan interest if you meet the AGI income limit.
- Health Savings Account (HSA) – This savings tool is triple tax-advantaged.
- Retirement Plan Contributions – Eligible contributions to a traditional 401(k), 403(b), or Individual Retirement Account (IRA) can be used in above-the-line deductions. Just be sure to stay within the contribution limits.
- Charitable Distributions – If you’re 70 or older, the IRS lets you make charitable contributions directly from your IRA to an eligible charity.
Below-the-line deductions are determined after your AGI has been calculated. These deductions are only available to those who itemize their deductions rather than take the standard. In essence, below-the-line deductions are itemized deductions.
Below-the-line deductions (or itemized deductions) include:
- Medical expenses that exceed 7.5% of your AGI
- Qualified charitable contributions
- Mortgage interest (on mortgages up to $750,000)
- Qualifying state and local taxes.
Tax Bracket Management
Whether it’s income deferral or acceleration, either can reduce your income and capital gains taxes.
Deferring income is the opportunity to delay receiving income or revenue until the following year. Income acceleration means bringing money into the current tax year.
When would these strategies make sense? If you believe you’ll be in a lower tax bracket this year and a higher one next year, it could make sense to accelerate your income. If you’re entering retirement and expecting to be in a lower tax bracket, it might be wise to delay your income until then.
This type of strategy doesn’t necessarily work for everyone (especially those who might be salaried) and is commonly used by commission-based or self-employed individuals.
How Abacus Can Help
The transition to retirement can be complicated, even before taxes are considered.
At Abacus, we understand that money isn’t the only goal, rather, it’s a tool to help you achieve fulfillment. Whether giving to charity, saving enough money to retire somewhere sunny, or retiring early, we want to help you create a comprehensive financial plan aligned to your values and help you expand what is possible with money.
Reach out to us today to make tax planning a fulfilling tool for your pre-retirement life.