With spring comes the anticipation of warmer weather and flowers in bloom. Unfortunately, spring also finds a lot of us scrambling to answer two important questions: How do I reduce my current tax bill, and what can I do to reduce next year’s tax bill?
Here are some tips to help you reduce your liability at tax time while also pursuing your family’s education and retirement savings goals.
The best place to begin reducing your tax bill is a tax-advantaged savings account. If you have a 401(k) account, you can contribute up to $18,000 in 2017, plus an additional $6,000 if you are age 50 or older. Combined with your company contribution, you can save up to $54,000 pre-tax, or $60,000 including the catch-up contribution. This strategy has the added benefit of growing your retirement nest egg.
An Individual Retirement Account (IRA) also offers current-year tax savings. For 2017, the contribution limits are $5,500 plus $1,000 if you are age 50 or older. If you are married, each spouse can contribute to an IRA even if only one spouse has earned income. Deductions for IRA contributions do have income restrictions, so it’s important to talk with your advisor for details.
HSA & FSA
Two additional options for reducing taxes through savings are Health Savings Accounts (HSAs) and Flexible Spending Accounts (FSAs). Designed to set aside funds for medical expenses, HSAs are one of the best ways to save because your contributions are tax deductible. Further, you can invest your contributions and generate tax-free growth. Your withdrawals to cover health care costs are also tax-free. No other type of account offers these three significant tax advantages. For 2017, the limit on an HSA is $6,750 for a family, $3,400 for an individual, and $1,000 catch-up for those age 55 and older.
Flexible Spending Accounts (FSAs) are designed to save pre-tax dollars for eligible health care expenses. Like HSAs, FSAs allow tax-free contributions and distributions. However, unlike HSAs, FSAs don’t allow the accounts to be invested. They also require you to spend most of the balance each year with a limited dollar amount available as a carry-over. Many of the rules (such as eligible expenses) for FSAs are determined by your employer, so it’s necessary to understand your specific plan’s limitations. The contribution limit for FSAs in 2017 is $2,600.
If you have dependents who require care, you may want to consider a Dependent Care FSA. Dependents can include minor children, a spouse who is disabled, or an elderly parent. For 2017, you’re allowed to set aside up to $5,000 tax-free to pay for eligible dependent care costs. Check with your advisor regarding the advantages of a Dependent Care FSA versus claiming a deduction on your tax return, as the benefit varies according to your income and number of dependents.
Education expenses are often overlooked as an area of tax savings. If an employer pays for your education, it does not count as income. If you pay for education yourself, tuition and other expenses are often deductible. Your advisor can help you navigate the rules that apply for the education expenses of yourself and your dependents.
There are both financial and emotional benefits to charitable giving. If you’re planning to make a significant gift to charity, consider giving appreciated stocks or mutual fund shares that you’ve owned for more than one year, instead of cash. Doing so supercharges the saving power of your generosity. Your charitable contribution deduction is the fair market value of the securities on the date of the gift, not the amount you originally paid, and you never have to pay tax on the profit.
Conversely, don’t donate stocks or fund shares that lost money to charity. In that case, it’s advisable to sell the asset, claim the loss on your taxes (thereby reducing your tax bill), and donate the cash proceeds to charity.
Tax-Smart College Savings
Placing money in a custodial account for future college tuition expenses can help you save money on taxes. However, this method has several drawbacks. Your account can be subjected to “kiddie tax” rules that vary based on your income and marginal tax rate. Custodial accounts also give full control of the assets to your child when he or she turns 18 or 21, depending on your state.
Using a state-sponsored 529 College Savings Plan can make earnings tax-free while giving you complete control over the funds. If, for example, one child decides not to go to college, you can switch the account to another child or take it back. The 529 Plan’s flexibility is one of its greatest benefits.
Using a Roth IRA to Save for College
It’s true that the “R” in IRA stands for retirement, but because you can withdraw contributions tax-free and penalty-free at any time, the account can serve as a terrific tax-deferred college savings plan. For example, say you and your spouse each contribute $5,000 to a Roth IRA starting the year your child is born. After eighteen years and assuming 8% annual growth, the dual Roths would hold about $375,000. Up to $180,000 - the total of the contributions - can be withdrawn with no taxes or penalties. Part of the interest can also be withdrawn penalty-free to pay eligible college expenses.
Fund a Roth IRA for Your Child or Grandchild
As soon as a child has income of any kind (babysitting, paper route, working retail), he or she can have an IRA. The child’s personal money doesn’t have to be used to fund the account, however. Instead, a generous parent or grandparent can contribute funds or match the child’s contributions dollar-for-dollar. Long-term tax-free growth in such a scenario can be remarkable.
We’ve seen two ways that contributions to Roth IRAs can help your children or grandchildren while saving you money at tax time. A frequently asked question your advisor can help answer is whether you should switch from a traditional IRA to a Roth IRA. Doing so requires paying tax on the converted amount, but this can still be a very valuable tax-saving investment because future earnings in the Roth account are tax-free in retirement. Withdrawals from traditional IRAs are taxed in your top tax bracket.
Consult with an Advisor
There are a variety of steps you can take today to reduce current and future tax bills. Making smart decisions within the framework of your individual financial plan could save you tens of thousands of dollars or more in taxes over your lifetime.
If you would like to learn more about any or all of these strategies, or if you are unsure how a specific strategy could impact your financial plan, request a call with an advisor at RAA.
Disclaimer: This blog is intended for informational purposes only and should not be construed as individual investment advice. Actual recommendations are provided by RAA following consultation and are custom-tailored to each investor’s unique needs and circumstances. The information contained herein is from sources believed to be accurate and reliable. However, RAA accepts no legal responsibility for any errors or omissions. Investments in stocks, bonds, and mutual funds may increase or decrease in value. Past performance is no guarantee of future results. Any of the charts and graphs included in this blog are not recommendations for the purchase and sale of any security.