Today I want to share a few ways that you can make smart decisions with your investments now to manage the tax impact when you file next April (and for years to come).
Let's start with a positive scenario: you made more money this year than you anticipated. More income means higher income tax, right? But you can shift the tax burden of this year's extra income into a future year (when you would presumably have less income) by maxing out your contributions to tax-deferred accounts like 401(k)s, IRAs, and HSAs.
Tax-deferred accounts work like this: to encourage people to save for things like retirement and health expenses, the government allows contributions to certain types of accounts to offset current year income. While it's true that you'll have to pay ordinary income tax when you take money out of retirement accounts during retirement, the upside is that you have some flexibility on when & how much you take out. For example, once you retire and your income drops, you could choose to take out just enough to fill up a specific tax bracket and no more, allowing you to decide how much tax you'll have to pay each year.
HSAs are their own thing, though, and have the largest tax advantage of any account: you get a tax break when you contribute, your money can grow tax-deferred while in the account, and distributions for qualified medical expenses are completely tax free. If you have high-deductible health insurance (minimum deductible of $1,600 for individuals and $3,000 for families), contributing to an HSA is one of the best ways to save on taxes.
What if you have the opposite scenario: what if you actually made less money this year than you anticipated? There are still opportunities to make investment decisions now that will help you avoid taxes later. While they involve adding to this year's taxable income, you have a ton of control over that impact and avoid paying those taxes later during a high-income year.
One idea is to use this lower-income year to realize some capital gains. When you invest money in a non-retirement account and those investments grow, the portion that exceeds your original investment is called capital gains and tax is due when you sell. (However, as mentioned in last week's newsletter, long-term capital gains are alwaystaxed lower than regular income.) So selling appreciated investments during a year with a lower than normal income lets you recognize some of those capital gains when their is less impact. And you get to control the tax impact by, for example, only selling enough so that the capital gains fill up your current tax bracket.
Similarly, you can also use a low-income year to do what's called a Roth Conversion. Roth conversions involve taking retirement money in Traditional accounts (like the ones discussed above where contributions offset current year income) and moving it into a Roth IRA or Roth 401(k). This is a taxable event (the amount of the conversion counts as current year income), but the advantages are that, again, you get to choose the amount to convert (and therefore the amount you'll pay in taxes). And once converted, you will never have to pay taxes on that money ever again. So a low income year is an excellent time to explore Roth conversions.
The reason we look at this stuff at the start of October is that there is still plenty of time to make the right moves before the end of the year. Not everything in the world of banking & investing moves at the same modern, instant-click pace that we're used to, so it helps to start thinking about and implementing these moves well in advance.
Let me know if you have any questions. I'm happy to have a conversation about any of this stuff!
Thanks,
Timothy Iseler, CFP®
Founder & Lead Advisor
Iseler Financial, LLC | Durham NC | (919) 666-7604
Iseler Financial helps creative professionals remove stress while taking control of their financial lives. We'll help identify your current strengths and weaknesses, clarify and refine your long-term goals, and prioritize decisions to improve your financial well-being now and later. Reach out today to take the first step.
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