So Many Questions
Congratulations, you filed your tax return. Did you get a big refund? Is that a good thing? Did you have to pay additional taxes with your return? Is that a good thing?
What can you learn from filing last year’s return that will help you reduce your taxes in the coming year?
Do you bring your tax return to your reviews with your financial advisor? What might they be able to tell you about that return, and how can it help you plan for this year’s return?
Capital Gains Distributions
Over the past few years, as the stock market has risen dramatically, so have distributions from mutual fund companies, attributable to capital gains that the funds realized and the distributions of those capital gains they were required to make.
I have three comments regarding those capital gains distributions.
- I love capital gains distributions. Although they are taxable, you are usually paying taxes at a lower rate than you would otherwise pay on ordinary dividend distributions (other than on qualified dividends that are taxed like capital gains). If you are below a 22% bracket, you’re not even paying tax on those distributions. Even if you’re in a 22% tax bracket, those gains are taxed at only a 15% rate. That is a tax benefit.
- A suggestion: Have those capital gains distributions paid in cash. I see three benefits. First, you will have cash from those distributions available to pay any taxes you might incur on those distributions. Secondly, you will build up your cash reserves as a pool to be available to you for spending on things you might not otherwise purchase. And third: You’re not adding to the cost basis of the particular funds from which they are distributed. Instead, you can use the cash to rebalance and diversify your portfolio by buying other funds.
- Lastly, definitely talk with your advisor about the tax benefits of owning certain exchange-traded funds that distribute little or no capital gains.
Roth Conversions
If you are retired and no longer have earned income, you should consider whether to convert part of your IRAs to Roth IRAs.
In the decades that the Roth IRA has been in existence, I have read way too many articles that suggest that people should convert their IRAs to Roth IRAs. Fortunately, I periodically come across an article that gets it right. You should use your tax return to help you determine whether you can convert to a Roth IRA at a very low tax rate or perhaps with no tax at all.
Roth conversions only make sense, from my perspective, if they result in your paying less taxes now then you would otherwise have to pay at a later point in time.
It is also important to consider the impact of the additional income from the Roth conversion on the additional tax you pay on Social Security when your income exceeds certain levels.
Again, these are sometimes complicated decisions. I encourage you to talk with your investment advisor about the tax consequences of any potential Roth conversions. And you should definitely review those decisions with your tax return preparer or other tax professional.
Optimizing your Contributions to 401(k) Plans, IRAs, and Roth IRAs
While you are still working and earning, conversion should take a backseat to contributing to retirement plans for which you are eligible.
From my perspective, you should first maximize contributions to your deductible 401(k) plans, 453 plans, 457 plans or any other qualified retirement plans. If your tax bracket is higher while you are working than you anticipate it to be during retirement, then contributions to deductible vehicles is preferable to adding money to Roth 401(k) plans, for which you will not obtain an exclusion from your income.
To develop a significant pool of investments from which you will be able to draw tax-free after you turn 59 1/2, those who qualify should consider maximizing contributions to Roth IRAs. Again, I think they should be done after maximizing deductible contributions to their 401(k) and other qualified plans. Furthermore, maximizing those exclusions can help keep you from being disqualified from contributing to Roth IRAs by lowering your modified adjusted gross income.
Qualified Charitable Distributions
All too often, individuals rush to convert IRAs to Roth IRAs, sometimes paying too much in taxes for that opportunity. Furthermore, if one makes a regular habit of contributing to charities, they should not overlook the opportunity to contribute up to $111,000 per year per person to qualified charities, typically 501(c)(3) organizations.
Whether those contributions are made by you directly with a checking account connected to your IRA or by the custodian of your IRA directly to charitable organizations, they help reduce the amount of your required minimum distributions that would otherwise be subject to tax. For those who are charitably inclined and have reached the age of 70½, I know of no better way to save taxes and benefit charities at the same time.
Which is Better, Getting a Refund or Having to Pay Tax When You File?
Rather than getting a significant refund, it is generally best to pay any remaining taxes due when you file. This way the government doesn’t have the use of your cash, you do. You can optimize the returns on that cash by accumulating it in higher yielding money market accounts. However, it is important to realize that the IRS requires your taxes to be paid generally through withholding or on a quarterly basis in advance of the filing deadline. If you’ve not paid a required amount of tax by that April 15 deadline over the course of the year, not just on that date, you can be subjected to interest and penalties on the underpayments. This is something you should discuss with your tax return preparer now so that you don’t end up in penalty territory on this year’s return. It is important to know that although withholding is available on individual retirement distributions and required from 401(k) plan distributions, there’s generally no withholding on ordinary dividends and capital gains distributions paid from your taxable accounts.
Bring Your Tax Return to your Reviews
There is no better place to start your tax planning than in your periodic reviews with your investment professional. Hopefully they can give you some ideas as to ways you can reduce your taxes and optimize your returns. And there is no better time to start planning for this year’s return than now.