Year-Round Planning

Logan Murray

MANY FOLKS SPEND December frantically hunting for ways to cut their taxes, whether it’s realizing losses in their taxable investment accounts, making charitable donations or raising their 401(k) contributions for the year’s final few paychecks.

A better strategy: Manage your taxes year-round rather than just at year-end. Filing a tax return is a reactive process—a record of income and deductions that have already occurred. It takes foresight and action to shape what those lines will look like on next year’s tax return.

The process of tax management starts with evaluating your situation. I suggest running a tax projection or reviewing your prior year’s tax return if you expect a similar financial year. We’ve all heard the basics, such as giving more money to charity, bunching deductions in high-income years and making Roth conversions in low-income years.

This is sage advice that can help you manage your tax bracket or help you stay within the tax code’s phaseouts for various tax breaks. But there are some additional strategies and actions you can take nearer the start of the year to gain more control over your taxes.

Portfolio construction. Asset allocation is a key pillar of portfolio construction. But have you also considered your asset location? Ideally, you’d hold tax-inefficient investments—those that kick off large amounts of ordinary income—in a tax-deferred account. That way, those gains go untaxed until you withdraw them. Meanwhile, you’d want to hold tax-efficient investments—those that generate long-term capital gains—in taxable accounts.

Investment structure. Mutual funds are often less tax-efficient than exchange-traded funds (ETFs). This may not matter if you’re an index investor, because turnover is low in either structure. An actively managed mutual fund, however, will likely have greater turnover and larger taxable distributions than an ETF.

Contribution limits. Make the most of tax-advantaged accounts. In 2022, the contribution limit for 401(k)s and 403(b) plans is $1,000 higher, with the max now set at $20,500 for those under age 50 and $27,000 for older workers. If you can afford it, adjust your payroll withholding to max out by year-end. The maximum contribution to health savings accounts has also increased a bit, to $3,650 for an individual and $7,300 for a family in 2022.

Tax diversification. Yes, the immediate tax savings from funding tax-deductible retirement accounts are enticing. But also give some thought to your tax bills during your retirement years. It might make sense to fund Roth accounts instead. If you don’t know which is best, diversify across taxable, tax-deductible and Roth accounts.

Withholding strategy. None of us wants to pay more than necessary to the IRS or our state government. To that end, have a plan to pay taxes throughout the year to avoid any interest or penalties for late payments. The IRS and state agencies expect you to pay along the way, not just at the end when it comes time to file your return.

To avoid penalties, you can increase withholding on your W-4 form if you’re employed or on a W-4V for your Social Security income. Another option is to make quarterly tax payments by check and voucher or by enrolling in the IRS’s Electronic Federal Tax Payment System.

Children. Gifting money from your estate will have no immediate tax benefit. But it can shift the tax burden of future asset growth to your children, who may be taxed at a lower rate.

Another common strategy is to contribute to a 529 college savings plan on a child’s or grandchild’s behalf. Contributions grow tax-deferred and distributions are tax-free if spent on qualified education expenses. Some states also allow a limited amount of 529 contributions to be deducted from state income taxes.

Have your own business? Consider hiring your child. You get a payroll deduction and your child can use the earned income to make Roth IRA contributions.

Bonus round. Now that we’re just past year-end, it can make sense to build on the tax planning you did late last year. Here are some items that come to mind.

First, if you harvested tax losses at the end of 2021, consider buying back into the original position 31 days after the trade, providing it makes sense for your taxes and your portfolio. Going forward, look for tax-loss opportunities throughout the year, not just at year-end. Similarly, if you sold a mutual fund to avoid a capital gains distribution in 2021, consider getting back into that same fund if it makes sense.

Finally, buy Series I savings bonds. With the new year, your $10,000 annual limit has reset, so you can take advantage of the current 7.12% annual yield. No federal taxes are due on your interest earnings until redemption, plus savings bonds avoid state income taxes.

Logan Murray is a solo financial advisor. His company Pocket Project offers subscription-based financial planning services to young professionals. For more financial insights, check out Logan’s blog or connect with him on LinkedIn. His previous article was COBRA Call Option.

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