When I was chief financial officer and we needed to save money in our corporate budget, we would look first at the largest expense items, see what we could cut there, and then work our way down through smaller expenses. A 10 percent reduction in our largest expense was much more beneficial than even a 50 percent reduction in our smallest expense.
So if taxes are one of your largest expense items, may I suggest putting real quality time and resources into reducing that expense first. I don’t suggest letting the tax tail wag the dog, but if you can reduce your largest expense item by 10 percent, it is probably worth more to you than skipping a night at the restaurant here and there.
Tax idea 1 — retirement planning
Our country needs self-sufficient retirees who can provide for themselves, and the government provides generous incentives to do so. If you don’t take advantage of these incentives — this free government money — you cannot go back later and claim these funds. We have shown many people how to save hundreds of thousands of dollars through pension planning, and several of these clients had previously been told that their pension plan contributions were already maximized.
Get a second opinion on your pension planning from a proactive planner or if you don’t have a pension plan, consider starting one. This one area could possibly be the biggest contributor to your tax savings and financial security.
One of my clients asked, “I could have been saving around $100,000 per year for the past decade?” Sadly, this was the case, and once the years have passed it is difficult or impossible to go back and get those tax dollars.
Although some pension planning ideas are available after the end of the year, the majority require action before the last day of the year. If you missed the boat on this one in 2012, there is always 2013.
Tax idea 2 — standard deduction for itemizers
Ever wonder what the standard deduction is for? Even those who pay no property tax, mortgage interest or charitable contributions still get the benefit of the standard deduction. You may be paying $12,200 in itemized deductions and the guy next door may be paying $0 in itemized deductions, yet you both get the same write-off.
Well, here is your chance to get more of your fair share of this benefit. We have had success with clients grouping all of their itemized deductions for two years into one year, and then taking the standard deduction in the other year.
Some itemized deductions are difficult to move, and in some cases you may not pick up the entire $12,200 increase in deductions, but even if you pick up two-thirds that amount and you are in the 25 percent federal and 5 percent state bracket, that could mean an additional $2,400 in your pocket every other year! Say this process takes a couple of hours of your time to implement — that is a cool $1,200/hour in tax savings … not bad!
Tax idea 3 — liberate passive losses
I had a client with several years of suspended passive losses that looked like they might never get to be deducted. This is because you can only deduct a passive loss against passive income. Here are a couple of ideas to liberate those suspended losses, either reduce the passive loss by shifting expenses to a category that can be deducted, or generate passive income.
For example, if you have a rental property that is generating losses, you could consider taking out a mortgage on your primary residence and shifting the deduction there, or purchasing one of the many investments that generate passive income and allow your suspended losses to shield that income from taxation.
Remember that you are limited in the amount of home equity interest you can deduct. Just don’t pass away with suspended passive losses, or the benefit may be lost forever.
Tax idea 4 — tax credits
A few years ago, one of my friends told me about a free electric car that you could get through tax credits. I quickly told him this follows the old axiom, “if it sounds too good to be true, it most likely is.” However, in this case my friend was right!
Many tax credits are frequently missed, including the small-business health insurance credit, education credits, and other general business credits. Some education credits are roughly equivalent to a full-ride scholarship, and some entire industries or businesses are built on tax credits. Make sure you investigate options in this area.
Tax idea 5 — tax deferred exchange
If you have rental properties or other highly appreciated assets, you may know that when you sell one of these assets you do not have to pay the tax now if you exchange the property into a “like-kind asset.” We have helped clients exchange millions of dollars of highly appreciated real estate into income-producing replacement property with no tax bill.
In addition, many replacement properties give the owner the benefit of additional depreciation deductions that reduce the amount of tax paid on that replacement property income.
So, you may ask, what happens to the gain? The gain is deferred into the replacement asset, which can be donated to charity, gifted to children or grandchildren, or simply held on to for the rest of the owner’s life. Each of these strategies may result in little or no tax. I like to think of this as harvesting fruit from the orchard rather than chopping down the tree for the temporary benefit of firewood.
Caveat — As you are improving your situation, don’t forget about Congress’ sneaky trick — the alternative minimum tax! When you see a nice “tax reduction” gift from Congress, if it is not married to a similar change in the alternative minimum tax, the new deduction may be worthless.
As you look at different scenarios, make sure you take the AMT into consideration, otherwise all your planning may be for naught. Make sure that you run your tax computation for both regular and alternative minimum tax to give greater assurance that your planning efforts will pay off.
5 more smart ideas to get the most on your tax return
As promised, here are five more.
Tax idea 6 — get a second opinion
Sometimes we feel that with all the technology we have available to us we can just do our own tax planning. Very simple tax preparation, possibly, but tax planning? I don’t think the technology is quite there yet. We have seen new clients try to save money by doing taxes on their own, and have then shown them where they have left thousands of dollars on the table.
Sometimes we have amended previous returns and gotten thousands of dollars back, but the IRS generally allows you to go back only three years, so in some cases, thousands of dollars were left on the table in previous years, never to be recovered.
If you are dead set on preparing your own return, I recommend at least getting a second opinion from a proactive tax planning expert to see what you may have left on the table. We have clients who received more than 10 times the fee charged in tax savings, and sometimes practitioners will perform this second opinion service for free, in hopes of creating goodwill and possible future business.
Tax idea 7 — excess RMD distributions
The federal government always gets its tax! Not only does it tax earnings, but it wants to make sure that we recognize enough earnings to keep the government wheels rolling. Required minimum distributions (RMDs) must be taken each year from your IRA after age 70½, so the government can tax you on these funds.
If you don’t take enough out, the results are rather draconian. Up to 50 percent of the amount you should have taken as distribution, but didn’t, can be taken away in taxes — ouch! Many people take only what they have to, which is a good idea in many cases, but in some cases, you may want to take out more than you need.
We have instructed some clients to increase their IRA withdrawals above and beyond the amount required to be distributed via RMD because they are in a low enough tax bracket that little or none of this additional withdrawal will be taxed. They don’t have to spend this money, but it is a nice way to get it run through the tax systems at little or no tax cost so that it can be spent outside the IRA or pension plan in a later year when they may be in a higher tax bracket. This is one of those benefits you have to use or you lose it. You can’t go back and take those distributions after year end.
Tax idea 8 — harvest capital losses and defer capital gains
When it comes to taxes, gains do not necessarily equate to more income tax. Even with the new 2013 higher tax rates on capital gains for those with income in higher brackets, there are many strategies that can reduce or eliminate altogether the tax on capital gains. For example, when the market declined in 2007 and 2008 we helped clients recognize the tax losses, and now the investments have appreciated, but are in tax efficient funds so those gains have not been taxed.
One of our clients recognized more than $500,000 in losses on the client's tax return, but has actually gainedhundreds of thousands of dollars that have not been taxed.
Tax idea 9 — donate gains or step up basis
Proper tax planning and investing may generate large untaxed capital gains. How do you reduce that tax hit? Rather than donating cash to your favorite charity, donate the property that has large capital gains instead, and you may be able to avoid tax on the entire gain, permanently.
Furthermore, if you want to give money to a child or grandchild, why not transfer these highly appreciated shares to your child instead, and let the child sell the shares. In many cases, the child may pay little or no taxes on capital gains, but still receive the same economic benefit.
Consider taking advantage of the step up in basis at death by deferring these gains throughout life and then after you pass away, if properly structured, your heirs can sell the assets the next day and pay no tax!
On a side note, beware of annuities that may convert capital gains into ordinary income, thereby removing the opportunity to use these capital gains strategies. Furthermore, non-annuitized withdrawals require all gains to be distributed and taxed as ordinary income, before you get any of your original purchase amounts back. There are some instances where an annuity might make sense, just make sure you understand the tax impacts before you invest.
Tax idea 10 — tax managed investments
Be smart about your investments, pick funds that are tax managed or attempt to match gains with losses or have very low turnover so that you're not constantly generating gains that you have to pay tax on. Taxes have a tremendous negative impact on your overall return.
When you compare investments, make sure you include the tax effect of gains on dividends, interest and capital gains from schedule B and D of your return. Focus on the after tax return, because it matters more what you keep than what you earn.
People complain about the market, but over the last decade our clients have almost doubled their money in a boring, well-diversified, inexpensive portfolio with little turnover, and without ever leaving the market.
Don’t worry about the market, you cannot control the market, but you can control taxes and fees paid, so focus on the things you can control and forget about the things you can’t.
Caveat — As you are improving your situation, don’t forget about Congress’ sneaky trick — the alternative minimum tax. When you see a nice “tax reduction” gift from Congress, if it is not married to a similar change in the alternative minimum tax, the new deduction may be worthless.
As you look at different scenarios, make sure you take the AMT into consideration, otherwise all your planning may be for naught. Make sure that you run your tax computation for both regular and alternative minimum tax to give greater assurance that your planning efforts will pay off.
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