Unless you requested a tax filing extension, you’re probably under the impression that tax season is over – you can sit back and relax until 2023. Not to burst your bubble, but if you want to be more tax efficient, you couldn’t be more incorrect. In fact, once you have your 1040 return in-hand, the hard work is just beginning. In this episode of The Agent of Wealth Podcast, host Marc Bautis digs deeper into the 1040, uncovering which areas you should focus on for improving your tax savings.
In this episode, you will learn:
- Reasons why tax planning should be done year-round.
- The key sections of a tax return to look at when performing an analysis.
- Potential tax-saving strategies – like Roth conversions – and investment tools – like ETFs.
- Planning opportunities to look out for while conducting a review.
- And more!
(For Clients): How to Upload Your Tax Return to Your Vault | Bautis Financial: (862) 205-5000
Welcome back to The Agent of Wealth Podcast, this is your host Marc Bautis. On today’s show I’m going to talk about how to analyze your tax return to uncover planning opportunities.
Taxes cut across almost everything we do financially. The investments in your portfolio all have different tax consequences depending on the dividends, interest or capital gains they generate. If you are retired, and drawing down on your assets, the taxes you owe depend on the strategy you use. There are tax beneficial ways to save for college, and the same goes for leaving money to your heirs.
Everyone wants to be tax efficient, but they’re not sure how.
Here’s the caveat: the typical, annual tax return flow that most people follow isn’t always strategic or tax-efficient. Typically, a person pulls together all of their documents in February or March, sends them to their CPA, who then generates their tax return, filed on or before April 15th – unless they file for an extension. These individuals don’t think about taxes again until the following year, when they repeat this process.
Even if these people uncover tax strategies in February or March, it’s too late, because most of the tax deadlines were the previous December 31st.
That’s why I’m here to tell you that tax planning should be a year-long activity that begins right after you file your tax return.
Now, I’m going to talk a little bit about the important things your tax return can tell you and what potential planning opportunities can arise from it. Let’s do this through the lens of a tax report that we produce.
Analyze Your Tax Summary
First, you want to look at a breakdown of everything that’s going on in your individual situation. Depending on how many Schedules you file, the 1040 tax return can be complex. It’s important to understand, at a high level, the following information:
- What was the total income you earned for the year?
- What deductions and credits did you have?
- What was the total tax you paid, your average tax rate and marginal tax rate?
- Did you have any carryforward losses, dividends, interest or capital gains?
Let’s dive into each of these areas.
Determine Your Marginal Tax Rate
If your goal is to manage your tax bracket more efficiently, you should know your marginal tax rate. This is at what rate the next dollar of income will be taxed, and how much additional income you can earn without bumping yourself into a higher tax bracket.
A planning opportunity that can present itself in this area is Roth conversions. In the above example, the individual is in the 12% marginal tax bracket and has $32,928 of additional taxable income ($78,950, bottom of 22% bracket, minus $46,022, their current taxable income) before they are bumped up into the 22% tax bracket.
If you have an IRA with pre-tax money in it, you can pay the tax now and convert some of it to a Roth at the 12% tax bracket. The benefit is that once it’s converted to a Roth you won’t have to pay taxes on it again – as long as distributions are taken after the age of 59½.
If you look at the tax brackets, you’ll see there are big jumps from 12-22% and from 24-32%. If you are in the 12 or 24% bracket, Roth conversions are definitely worth looking into.
Even if you are in the top bracket of 37%, a Roth conversion in the current year may make sense if you think tax brackets will be higher in the future. While this is something that no one knows for sure, there is always a chance.
Standard Deduction vs Itemizing
Next, let’s look at the difference between itemizing or taking the standard deduction.
In 2017, the Tax Cuts and Jobs Act was passed and the standard deduction was nearly doubled in size. Since then, a lot less people itemize on their tax return. For 2022, the standard deduction is $12,950 for singles and $25,900 for those who are married filing jointly.
Examples of Itemized Deductions
- Amounts you paid for state and local income taxes
- Real estate taxes
- Personal property taxes
- Mortgage interest
- Disaster losses
- Gifts to charity
If your eligible itemized deductions are less than your standard deduction you would just take the standard deduction. However, there is a strategy with charitable giving called bunching your deductions, which may make sense depending on the individual. In this case, you’d take the standard deduction one year and itemize the following year.
For example, let’s say a married couple filing jointly has itemized deductions of $25,000 per year, of which $10,000 is charitable giving. Their $25,000 of itemized deductions is less than the $25,900 standard deduction, so they think it makes sense to take the standard deduction. But, if instead of giving $10,000 every year, they gave $20,000 one year and $0 the next, they can itemize $35,000 the year of the donations and take the standard deduction the next year. They would still give the same amount of money, but would get an extra $10,000 in deductions every other year.
Investment Income and Capital Gains and Losses Review
To make sure your investment portfolio is properly constructed, you have to look at your investment income. You want to know how you’re being taxed on your investment income – since different types of income are treated differently – and if there’s a way to alter your portfolio to be more tax efficient
Qualified Dividends: If your taxable income falls below $41,675 if you are single or $83,350 if you are married filing jointly, you do not have to pay any tax on what you receive. If your taxable income falls between $41,674 and $459,000 if you are single or $83,000 and $517,000 if you are married filing jointly, you pay 15% tax on qualified dividends. If you are over those limits you would pay 20% tax on the dividends.
Non-Qualified Dividends: If the dividends are non-qualified, you would pay tax on them as if they were ordinary income.
Most bond interest you receive is taxed as ordinary income, however there are certain types of bonds, like municipal bonds, that may be tax exempt.
It’s not just income you need to be concerned with. You want to look at any capital gains or losses. Capital gains can be classified as either long-term or short-term. If they are long-term (the investment was held longer than a year), they are taxed the same as qualified dividends. If they are short-term capital gains, they are taxed at ordinary income rates.
Here’s an example of a very inefficient type of investment, as well as a strategy of how someone can be tax efficient when it comes to gains and losses.
Some people own “active” mutual funds in their portfolio. An active mutual fund is one where the fund manager buys and sells securities within the fund. If you own one of these funds, you may see a large capital gain on your tax return and wonder where it came from… It’s because the fund manager was making trades and any capital gains within the fund are passed down to the individual investor – whether or not they sold their shares of the fund.
Exchange traded funds (ETFs) are typically more tax efficient than actively managed mutual funds. There is a way to take it one step further by implementing a strategy called direct indexing.
I’ll use an example to illustrate how direct indexing works. Let’s say you’re going to invest in an S&P 500 ETF. There may be periods where the ETF is down in value, but over a longer period of time the ETF’s price per share will probably be more than what you paid for it. If you don’t want to harvest a tax gain and owe taxes, you’ll be locked into keeping that fund. However, you can instead invest in the underlying 500 stocks that make up the S&P 500. Even if the overall S&P 500 goes up over a period of time, inevitably not all 500 stocks will increase in unison. You’ll be able to sell the ones that have gone down in value and harvest a tax loss. Utilizing this strategy, you’ll have the same return as if you invested directly in the ETF, the same amount of risk as the ETF, but will be more efficient tax-wise.
Benefits of Direct Indexing
- You can harvest tax losses to take up to a $3,000 capital loss on your tax return. And if there are more than $3,000 of losses, you can carry those losses forward to future years.
- The losses you harvest can offset capital gains you may have with other assets.
- You have control over what gets bought or sold, not the fund manager.
- You’re not limited to indexing off the S&P 500, you can utilize almost any investment strategy that you can think of.
If you want to learn more about direct indexing I have an entire podcast on the topic.
Other Reasons to Review Your Tax Return
Marginal tax rates, Roth conversions, standard vs itemized deductions and investment income are just a few reasons why you should be reviewing your tax returns. Other areas to look at include:
- IRMAA Surchases: This is an extra surcharge based on income added to your Medicare premiums. These additional charges can be sneaky, and you want to see if there are ways to plan around them.
- Net Investment Income Tax (NII): This is an additional tax for individuals who have Modified Adjusted Gross Income over $200,000 and married taxpayers with MAGI over $250,000. This investment income that is over the limit is taxed at 3.8% and often a surprise to higher income earners.
- Qualified Business Income Deduction (QBI): The tax cut and job act of 2017 includes a 20% tax deduction for pass-through businesses (subject to several requirements). It’s like a standard deduction for a business. All small business owners should be aware of this tax saving opportunity.
- Phaseouts: There are over 50 tax credits that are available, but they are subject to a variety of income phaseouts. You want to review your credits and deductions to ensure you’re not missing out on any tax savings.
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