Making mid-year tax changes can completely change your outlook for the year
Mid-year tax changes are a great way to make sure you’re even with the government come tax season. Remember, if you get a large refund, you’ve given the government an interest-free loan straight from your pocket!
One of the easiest ways to reduce your household income tax liability is to maximize your contributions to tax-deductible vehicles such as 401k, 403b, 457b plans. Each of these allow you to put away $18,000 which means you could take a tax deduction of $54,000. How much tax would this save you if you were in the 35% income tax bracket? That would be $18,900. Simply by shifting your income from once place to another can provide that much tax relief.
So what happens to the growth inside of these accounts and the income that you can take in retirement? It will be fully taxable. The idea here is to put as much as you can away while income tax rates are higher and then take distributions when the rates are lower. What if that is not how things play out? Right now we are in a record low income tax rate environment and the national debt as a % of GDP is on pace to reach its highest level. This would argue that it makes more sense to pay today’s taxes and avoid them in the future, if that’s possible. Some employer’s offer a Roth 401k or 403b option which in fact does allow for this. Any contributions from the employer via matching or profit-sharing must be treated as pre-tax contributions. So we’ve talked about the two extremes, taking the full deduction now and pay the tax later vs pay the tax now and have no tax later. What’s the best answer? If it was an easy answer, you’d be hearing it everywhere. The reality is there is no certainty to what the future holds. There are so many factors that can cause one option to be more favorable than the other.
Let’s take for example a client I met with recently who was going “all in” with Roth contributions toward his retirement accounts. His income was high enough that it would provide some serious relief to take the deduction but he wasn’t since the strategy he was banking on was that rates would be higher in the future and stay there. Probably a pretty good bet in light of how things look today, but what if there was more he could do which would enable him to get the best of both worlds?
That is in fact what we discussed. What if he maxed out each of the retirement plans so that he could get the full deduction? In his case it was two retirement plans through his employer and one for his wife. They qualified for and would be able to do this because they could build up after tax savings in Roth IRAs (with the conversion rule change) and inside of insurance contracts which are designed with a low administration cost with the ability to pull income out on a tax-free basis. For any high income person or executive who is able to max out their retirement plan in the first few months of the year and needs to find other places to warehouse money somewhere else on a tax favored basis, they can use a cash value insurance contracts to do it. There’s actually billions of dollars going into those contracts on a monthly basis, they are that common.
In light of our client’s situation he was able to utilize a strategy where he could increase his tax savings today and participate in the tax savings of other vehicles which do not require any taxes paid along the way and allow for tax-free distributions in the future. Feel free to contact us for ideas on how to approach tax savings. There are many ways to skin it.