With the tax deadline past, most of us are ready to turn to the more pleasant aspects of spring — tennis, golf or gardening, perhaps. But before you pack away all those tax papers, consider another look, for a head start on cutting your taxes for 2016 and beyond.
The return you’ve just done can provide some insights into ways to reduce future taxes, and many strategies work better if they are set up earlier in the year rather than later.
“The key to preparing for taxes next year is to prepare this year,” says Dave Du Val, vice president of customer advocacy at TaxAudit.com, a nationwide firm that helps customers with tax matters. “In other words, plan ahead.”
So what can your latest return tell you?
Look at your investments. If you own mutual funds in taxable accounts, see how much income you reported from interest, dividends and year-end capital gains distributions, which are profits paid out on assets the fund manager sold during the year. All these income sources are taxable in the year they are received, even if you have them reinvested in the funds they came from.
[Read: 13 Tips for Saving and Investing While Owning a Business.]
One alternative is to switch to funds that don’t pay out so much. If you have an actively managed fund that invests in stocks of large U.S. companies, you could switch to an index-style fund that tracks the Standard & Poor’s 500 index. You’ll still receive taxable dividends, but capital gains distributions may be considerably smaller because index funds do much less selling than managed funds. Instead, investment returns are reflected in rising fund share prices, so you won’t pay tax on gains until you’ve sold shares.
Or, if you are fond of managed funds that make big annual payouts, you could reorganize so that these funds are held in tax-favored accounts like IRAs or 401(k)s. That way you can postpone taxes until you take money out after turning 59½. If you qualify, you could buy these funds in a Roth IRA or 401(k) and never pay tax on distributions, interest or dividends.
The best candidates for tax-favored accounts are investments like taxable bonds, money market funds and real estate investment trusts, because interest earnings are otherwise taxed as ordinary income, with rates as high as 39.6 percent, or even higher for the wealthy, says Paul Pagnato, CEO of Pagnato Karp, an investment advisory in the District of Columbia.
[See: 7 Ways to Tell if a Stock Is a Good Price.]
Investments that provide gains through dividends and long-term capital gains, both taxed at a maximum of 15 percent for most investors, can be put into ordinary taxable accounts, where there are no restrictions on annual contributions, nor penalties for withdrawals before age 59½. Taxable accounts offer lots of flexibility.
Be sure to keep good investment records, Du Val says. That’s especially important when you reinvest dividends and capital gains distributions earned in taxable accounts, because that money, having been taxed when received, is not taxable again. Forgetting this can mean paying too much tax after profitable assets are sold.
Think about ways to reduce your taxable income. The easiest is to invest as much as you can in a 401(k) or similar workplace retirement plan that allows you to deduct contributions. The maximum contribution in 2016 is $18,000, or $24,000 for those 50 and older by the end of the year.
“Not only will you defer paying taxes on the contributions, but you will defer paying taxes on the earnings too,” says Robin M. Solomon, a tax and benefits attorney with Ivins, Phillips & Baker in the District of Columbia. “This allows the funds to compound tax-free until your retirement.” Try to contribute at least enough to get the maximum matching contribution, if you employer offers one, she says.
If you qualify, you also may be able to deduct an IRA contribution — up to $5,500 this year, or $6,500 for those 50 and older. Generally, investments earn more if made earlier in the year, though you could set the cash aside and wait for a dip in the financial markets, an option that may not be available late in the year.
There are other ways to shelter income from tax. “Individuals who have a high-deductible health plan may want to consider establishing a health savings account,” says Amy L. Libertoski, senior financial advisor at Wipfli Hewins Investment advisors, based in Redwood City, California. “Contributions to an HSA qualify for a deduction in determining adjusted gross income.” That would allow you to pay deductibles and other out-of-pocket expenses with untaxed money.
[Read: 3 Investing Tips to Last for the Next 365 Days.]
Also see if your employer offers a flexible spending account, which offers a tax break on savings for health care and taking care of dependents, Du Val says. Your employer can explain how these work.
Give money to charity. As long as donations are made by the end of the year they will count, but starting earlier will allow you more time to assess potential recipients.
Kay McFarlin, president of TIAA Charitable, a nonprofit that helps individuals select charities, suggests setting up a donor-advised fund. That would allow you to make a large contribution this year, with an immediate tax deduction, even if the money in the fund was parceled out over a number of years.
“You can get the benefit of a tax deduction right away and decide later on the charities you want to support,” McFarlin says. The fund can be invested, and the gains would be tax-free.
Another option is to give charity appreciated assets, such as stocks or funds. Libertoski says the donor “can deduct the full fair market value of the security as a charitable contribution, assuming they itemize their deductions, while avoiding paying tax on the appreciation that has taken place since they have owned the security. In order to qualify for this treatment, they must have owned the security for over a year.”
Think about your tax bracket. It could rise if, for example, a non-working spouse gets a job. And it could fall if household income drops — when a spouse stops working, for instance. If your bracket is likely to fall, this might be a good year to convert a traditional IRA into a Roth IRA, since the tax bite on the converted sum would be smaller. Once the money is in a Roth, it — and all future investment gains — will never be taxed again.
The list of ways to reduce taxes is includes everything from investing in municipal bonds to hiring your children in a family business to establishing trusts for dependents. The point is: it’s complicated. Which is why the experts urge taxpayers to hunt for tax savings all year round.
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Start Now to Prepare for Tax Day in 2017 originally appeared on usnews.com
