“It’s not what you make, it’s what you keep.” Will Larson, a Retirement Planning Strategist with Wells Fargo Advisors, says that this is a favorite saying when referring to planning to reduce taxes. “It’s a simple concept,” he says, “but you’d be surprised how often investors lose sight of it.”
For most investors, there may be no better time to tackle tax planning: You have 2018 information to work with, and it’s still early enough in 2019 to make a difference—especially if you take a multi-year approach to your plan.
In the new tax landscape, with many traditional deductions limited or eliminated, tax planning for multiple years is more important than ever, says Kirk Pacatte, a Planning and Life Events Specialist with Wells Fargo Advisors. Plus, you can invest every dollar you save, which means the potential to earn more money going forward.
“Plot out your expected tax picture for the next three to five years,” Pacatte says. “You’ll possibly find some opportunities to save yourself some money.”
Here are three strategies that could help decrease your tax burden and increase your future after tax income.
1. Remember location, location, location
You’re no doubt familiar with asset allocation: the right ratio of stocks, bonds, cash, and other investments to balance risk and reward to help meet your long-term goals. From a taxation perspective, asset location—meaning the type of accounts in which you invest your money—can be just as important.
“It’s not only about what you own in terms of investments, but where you hold your investments,” Larson says. “A good plan doesn’t just help you reduce taxes, but can produce portfolio longevity”
Strategic asset location aims to take full advantage of potential tax benefits and to reduce tax exposure using different account types. Broadly, these account types are:
- Taxable: Portfolio income and realized gains from these accounts are taxed every year. Think stock gains, savings account interest, or stock dividends.
- Tax-deferred: Contributions and gains in these accounts are taxed when you take distributions. Think 401(k) plan or other workplace retirement accounts.
- Tax-exempt: Gains in these accounts have no tax exposure under the right conditions. Think Roth IRAs.
Larson says many investors don’t think enough about having assets in all three locations, or wait too long to diversify across different types of accounts. “If I have all these buckets, I can more effectively seek to mitigate my tax burden, and improve how long I can withdraw from my portfolio,” he says.
2. Be strategic about itemizing
Fewer taxpayers will itemize deductions under the new tax law, thanks to the sharply higher standard deduction (in 2019, $24,400 for married/joint filers). But if you’re close to the itemization threshold, you may be able to “bunch” your charitable deductions and lower your overall tax liability over time.
Say you typically give $5,000 per year to a nonprofit. Consider a one-time gift of $15,000, with no donation over two other years. The charity will get the same donation, but you may be able to itemize the donation one year and benefit from a tax perspective.
“Plan the larger gift for a year where you’re expecting your income to be higher,” Pacatte says, “and you’ll be able to offset more of that income.”
You might also consider a donor-advised fund, which allows you to put charitable contributions into an account, take any appropriate deductions when you fund it, invest the money to potentially grow tax-free within the account, and distribute the money to qualified charities when you want, either immediately or years in the future.
3. Use RMDs to your advantage
If you’re at or near retirement, you can think about the tax efficiency of your required minimum distributions (RMDs). These annual distributions are minimum amounts that a retirement-plan participant must withdraw starting with the year he or she turns 70.5 (within exceptions). IRA account holders must start withdrawing at age 70.5.
If you are age 70.5 or older and typically donate to charity, consider a qualified charitable distribution directly from your IRA. That could lower your adjusted gross income (AGI) and help reduce taxes. “It’s not an itemized deduction, but the amount contributed reduces your AGI while counting towards your RMD, which benefits you now and possibly in the future,” Pacatte says. “A lower AGI can cut taxes on Social Security benefits and possibly lower your Medicare premiums.”
Conversely, if you believe your tax bracket may increase in the future, consider earlier distributions and pay that tax now at potentially lower rates. “Recognize that income now and it could lower your future AGI,” Pacatte says.