There may be only two or three things in your financial portfolio that jockey for the highest planning and efficiency needs, and taxes is one of them. The key is to take advantage of tax breaks and help mitigate tax liabilities using efficient and legal methods. Here are some key tax planning and strategy concepts to keep in mind as you think through your financial future.
As an employee, you start by filling out your IRS form W-4 during your orientation at work. That’s the form where you determine the amount of federal taxes your employer will withhold from your paycheck. Those withholdings will be reported on your yearly W-2. You’ll also elect your state tax withholding, depending on your home state. It would be ideal for you to talk with a tax specialist when completing your W-4 each year, so you’re not over or under withholding. It is also best practice to have your tax specialist do a midyear projection to determine whether you are on pace to break as close to even as possible for withholdings at the end of the year.
Remember that employers typically under withhold tax when you exercise stock options, because the required withholding is often lower than what your tax bracket may be for the year. If you don’t plan for the potential under withholding of taxes, you may find yourself holding a significant tax bill come filing time.
Know Your Tax Bracket
The U.S. tax system is a cash-basis system. That means you report income in the year you are actually paid. This is pretty straightforward for both your salary and any bonuses you may receive. Our tax system is a progressive tax system. Tax brackets are set annually as part of the tax code, and are determined by how you file and report your income. A lot can happen in any given year, from receiving an inheritance, getting an unexpected bonus or raise, or receiving stock options that could make your income jump in value. Since you can’t know what tax bracket you’ll be in much beyond this year, it’s at least important to know about how tax brackets work and which one you’re in. People with higher taxable incomes are subject to higher tax rates, while people with lower taxable incomes are subject to lower tax rates. In 2023, there are seven federal income tax brackets: 10%, 12%, 22%, 24%, 32%, 35% and 37%. They break down as follows:
No matter which bracket you’re in, you probably won’t pay that rate on your entire income. First, you get to subtract tax deductions to determine your taxable income, making your taxable income different than your salary or total income. Second, the government divides your taxable income into chunks and then taxes each chunk at the corresponding rate. This means you pay a certain amount of tax on the lowest amount until that threshold is reached, and then you pay a larger amount on the next bracket up, and so on.
Source: https://www.nerdwallet.com/article/taxes/tax-planning - 2/20/23
The Difference Between Tax Deductions and Tax Credits
Taxes are generally based on your adjusted gross income. Adjusted gross income (AGI) is your gross income minus certain payment you made during the year. Some examples of those payments are student loan interest, contributions to an IRA, or contributions to a Health Savings Account (HSA). The IRS uses your AGI as a basis for calculating your taxable income and to determine which deductions and credits you may qualify for.
As a note, your Modified Adjusted Gross Income (MAGI) is your total income before subtracting your student loan interest.
Tax deductions that reduce your AGI and are considered “above the line” reductions in taxes owed. Above the line deductions have to do with how much of your income is taxable. Deductions are things that you can subtract from your taxable income when calculating your taxes owed. The standard deduction is common for individuals and couples who do not itemize their taxes.
When itemizing taxes, other deductions become available. These deductions can make it possible for even greater reductions in the amount of income being taxed. Itemized deductions can make the process of doing your annual taxes more complicated. Itemized deductions are reported on Schedule A, for federal taxes, and may even be itemized on your state returns. Some examples of itemized deductions are student loan interest, charitable donations, medical expenses, mortgage interest, and HSA contributions.
Tax credits are “below the line” reductions in taxes owed. Tax credits are dollar for dollar reductions in your tax liability. An example of a tax credit is the child tax credit, residential energy credit for energy efficient additions to your home, or the adoption credit received when adopting a child.
Which is better…deductions or credits? Let’s look at an example:
Source: https://www.nerdwallet.com/article/taxes/tax-planning - 2/20/23
Tax Saving Strategies
After you’ve made sure you’re not over or under withholding on your W-4, there are a few strategies that can help you save taxes.
Your 401(k) and Other Employer Retirement Options
The first is to contribute to your 401(k). By doing this, you’re taking advantage of receiving a dollar-for-dollar tax deductions in your taxable salary while also receiving any matching contributions your employer provides. The 401(k) contribution limit increases over time, so you’ll want to be sure you’re checking on the amount you contribute every year during open enrollment for your company’s benefits, or annually at the beginning of the calendar year.
If you have the non-qualified deferred compensation option, determine if this makes sense because it can also greatly reduce your taxes.
Consider contributing to a Traditional or Roth Individual Retirement Account (IRA). Your household income may be too high for you to contribute directly to a Roth IRA, but you may be able to take advantage of annual Roth conversions. Sometimes called a “Backdoor Roth”, this option allows you to contribute up to the maximum allowable annual IRA contribution using after-tax dollars. Once per year, you are able to recharacterize those funds from the Traditional IRA to a Roth IRA. In 2023, the maximum contribution amount is $6,500. While this doesn’t seem like a large amount of money, it definitely adds up over time and can also be beneficial avoiding future tax liabilities created by contributing to a 401(k) or Traditional IRA with pre-tax dollars.
Health Savings Accounts
If you are enrolled in a high deductible health plan (as defined by the IRS), you are eligible to contribute to a health savings account (HSA). Even if your employer doesn’t offer an HSA through the benefits plan, you can open your own HSA account. HSAs can be one of the most effective retirement savings options available, no matter your income. While allowing for tax-deductible contributions, HSAs give account holders the option to have an investment account inside of their HSA that provides tax deferred growth for the investments inside the account. Best of all, if distributions are used for qualified medical expenses, they are tax-free, and there is no requirement for when these funds must be spent. Triple tax play!
If you’re healthy, a high deductible health plan is generally a good option to consider and can save you money. To really take advantage of the power of a HSA, consider paying as many medical expenses as possible out of pocket. That way, you’re treating your HSA like a retirement savings account, and you’ll have more funds available when you know you’ll have medical expenses but are no longer working. Any funds leftover at death can be passed to a named beneficiary income tax free.
Flexible Spending Accounts
If you know of larger expenses that will come up in any given year, or you have a dependent that qualifies for dependent care, a Flexible Spending Account (FSA) might also be a good tax-savings option. Some examples FSA funds are often used for are getting braces, certain medical costs, or knowing the approximate amount of money you’ll spend on day care each year. The IRS establishes the maximum you can contribute to an FSA each year. In 2023, the contribution limit is $3,050, or roughly $254 a month. One complication with FSA accounts is that if you don’t use the funds they will not roll over to the next year and you lose any remaining contributions back to your employer. Some employers will offer you a short grace period to finish spending the funds or submitting for reimbursements.
Donor Advised Funds
Whether you are charitably inclined or not, Donor Advised Funds (DAFs) are worth considering. A DAF is an account where you deposit funds to be donated to a charity over a period of time. The donor gets a tax deduction while a sponsoring organization manages the account. The donor can recommend which charities receive the funds and how the funds are invested. Though the sponsoring organization has the final say in there the funds are donated, they will usually heed the requests of the donor as long as the charity is in good status with the IRS.
It is possible to pre-fund several years’ worth of charitable gifts into a specified account and take the tax deductions in the years when contributions are made to the fund, regardless of when the charities ultimately receive the gifts. This can mean an immediate tax deduction for you when you’ve received an unexpected boost to your income.
For example, let’s say you’ve been receiving equity awards over the years, and you own a large amount of highly appreciated company stock. It is more advantageous to donate appreciated stock to a DAF than cash because a tax deduction can be taken for the full market value of the security as long as it was purchased more than a year prior to the donation. And because the securities are being donated, you won’t have to pay capital gains taxes when the stock is liquidated inside the DAF.
You won’t pay capital gains taxes on assets you put in a donor-advised fund, and if you donate assets that are worth more than what you paid for them, you typically can deduct the current market value of the asset rather than what you originally paid for the asset. If you are on a restricted trading list, you’ll have to donate to the DAF during an open trading window.
As an additional benefit, donations to DAFs can be anonymous if you choose to remain so.
Other Tax Advantaged Options
There are certainly other options available to you when considering how to be most efficient with your income, especially in years when you receive a windfall or larger-than-expected amount of money. Best practice is to consult trusted tax and financial professionals who can give you options and educate you on what you can do to help mitigate tax liabilities.
Guardian, its subsidiaries, agents and employees do not provide tax, legal, or accounting advice. Consult your tax, legal, or accounting professional regarding your individual situation. The information provided is based on our general understanding of the subject matter discussed and is for informational purposes only. 2023-155784 Exp. 5/25