MoneyMonday: Tax Planning Essentials

Welcome to this workshop, Tax Planning Essentials, the Basics of our Tax System. I’m Janel Cross, one of your MoneyNav coaches.

In our time together, we will cover… the basics of our nation’s tax system, the different types of income, various deductions, and credits, and finally, we will review some tax management strategies.

There are a variety of taxes we pay with the most significant being federal income tax.   Most of us will also pay state and local taxes. In some places, for example, in Philadelphia, there is an additional city wage tax. It’s important to know what types of taxes you pay based on your situation.

Also, different types of income are taxed at different rates. We will cover that in more detail soon.

Finally, the primary way to reduce your tax bill is to take advantage of credits and deductions. Unfortunately, the list of credits and deductions and the corresponding taxpayer eligibility changes regularly. For this reason, we recommend you consider working with a tax professional or use professional software to file your tax return.

I mentioned that MOST of us will be paying state taxes. There are some states that do not have a state income tax. You’ll probably recognize some of them as common destinations for relocating retirees. The absence of a state income tax is often a reason folks move to these states in their golden years. In addition to these states, New Hampshire and Tennessee do not apply a state tax to earned income but do tax some forms of investment income.

Let’s begin learning how to manage your tax situation. First, determine what your ordinary income is. Ordinary income includes (click and read). One note regarding Social Security income. For some folks, Social Security income is not taxed at all. For others, 50 to 85% of their benefit is taxed. The amount subject to income tax rates depends on your total household income. This is why tax planning is just as important in retirement as it is during your working career. It’s also a benefit of Roth savings which are tax-free in retirement if you’ve had the account for at least 5 years.

Ordinary income is subject to ordinary income tax rates which we will take a closer look at shortly

Unlike ordinary income, there are some forms of income that receive more favorable tax treatment including specific types of investment dividends deemed as qualified. This is reported automatically on your tax document. If your investment dividends are qualified, you pay tax at a lower rate called the Capital Gains tax rate. Because qualified dividends are not the most common form of dividend payment, check with a tax advisor regarding your situation.

Also, long-term investment gains are taxed at lower capital gains rates. To qualify, you must own the investment for more than 1 year. If you buy at a low price and sell at a higher price, the investment gain is taxable, even if you turn around and invest in a new stock. If you held the investment for less than 1 year, that gain is taxed at the higher ordinary income tax rates. If you hold the investment for more than one year before selling, your gain qualifies for the lower capital gains tax rate. This is important to consider if you are thinking of selling an investment that you purchased recently. We recommend investing in stocks and mutual funds as a long-term exercise and discourage investors from buying and selling quickly.

Update tax table. Let’s look at the difference between federal income tax rates that apply to ordinary income and the lower capital gains tax rates that apply to qualified dividends and long-term capital gains.

The maximum income tax rate is 37% for the highest earners. But the highest capital gains tax rate is 20%. Note that many taxpayers will qualify for the 0% tax rate on capital gains which means gains generated by selling profitable investments will not be subject to any tax at all. Especially when market returns have been strong, it’s worth “cashing in” some of your winnings especially if there is no tax consequence for doing so.

An important concept to understand is the difference between your marginal tax rate and your effective tax rate. Consider a married couple filing a joint return and earning $85,000 a year. What would their tax bracket be? If you looked at this table, you might guess 22%. And that is correct… as it relates to their marginal tax bracket.

Our tax system is called a progressive tax system. In other words, regardless of how much we earn, every married couple pays 10% tax on the first $20,550 of taxable income, 12% tax on the next $63,000, 22% on the next $65,000, and so on. Let’s look at an example…

Our married couple earns $85,000 per year. Remember, they pay taxes on their taxable income. That means their income after deductions which we will discuss in more detail in a minute. In this example, we assume our couple takes the standard deduction of $25,100 which excuses this amount of income from any taxation at all.

Now they are down to a taxable income of $59,900 which passes through the tax table. After all, is said and done, they pay a total of $6,793 on their $85k income for an effective (or actual) tax rate of 7.99%.

I count myself among those who dislike paying taxes. But I’ve also seen folks spend a lot of time trying to fiddle with tax strategies without truly understanding how much tax they are actually paying.

That brings us to step 3: knowing your deductions and credits. These are terms that are easily confused but their impact on our tax bill is very different.

Consider an $800 deduction vs an $800 credit. If your taxable income is $50k, that $800 deduction would reduce your taxable income to $49,200 on which you pay approximately 15% in taxes for a total tax bill of $7,380. The deduction saves 15% of $800 or $120.

On the other hand, a credit reduces your tax bill dollar for dollar. So, an $800 tax credit saves you $800 in taxes, reducing your tax bill from $7,500 to $6,700.

You can see that credits are more valuable than deductions. A primary focus of tax management is making sure you are getting as many credits and deductions as you can.

Snagging deductions and credits used to be a more common taxpayer activity but the 2017 Tax Cuts and Jobs Act nearly doubled the standard deduction. Today, the standard deduction is $25,900 for married taxpayers and $12,950 for single taxpayers.

what is the standard deduction and how does it impact your tax situation? Well, there are expenses that qualify as itemized deductions and can be claimed to reduce your taxable income. Examples of expenses eligible for itemized deductions include…

If you work with a tax professional or use tax software, you might be accustomed to providing the amounts you spend in these categories. But just because you provide the information doesn’t mean it’s actually used in calculating your tax bill.

You get to use EITHER the total of your itemized deductions OR the standard deduction, whichever is greater. You cannot, unfortunately, use both.

Here are some things to know about some specific deductions… medical expenses can only be itemized if they exceed 7.5% of your adjusted gross income. In other words, you must spend a lot of money on medical for it to reduce your tax bill. If you have any elective expenses, you might attempt to group them in the same year if you think you will exceed that 7.5% limit.

State and local taxes can be itemized but only up to $10k. So states with high state tax rates, like MD, DC, and Massachusetts, pay more in taxes than they can itemize. If you own an expensive home, only the first $750k to $1M of mortgage debt interest can be itemized.

Finally, charitable contributions which include monetary donations, non-cash items like clothing and furniture, or even appreciated investments can be itemized.

These are the most common items since many of the miscellaneous itemized deductions were eliminated in 2017.

Remember I said you get to claim the higher of your itemized deductions or the standard deduction. For most folks, the standard deduction will be higher. Let’s walk through two examples to be sure we understand…

Take a married couple with itemized deductions that total $22,500. Since that is less than the standard deduction of $25,900, they will claim the standard deduction on their tax return.

So, although you enter all those itemized deductions, it doesn’t mean you actually use them.

Here’s a different example of a single taxpayer who has itemized deductions of $16,500 which exceeds the standard deduction of $12,950. This means this taxpayer will claim their itemized deductions instead of the standard amount.

Let’s discuss some common tax credits. Remember, tax credits have a more significant impact on lowering your tax bill than deductions.

First the child tax credit. If you have children, you may qualify for a tax credit for each child. This credit is based on household income and is phased out as your income increases.

There are other family tax credits for households with children including the Family Tax Credit, Child Dependent Care Credit, and the Adoption Tax Credit most of which are also income dependent.

The Lifetime Learning Credit and American Opportunity credit are available for qualified education expenses or for yourself or a dependent.

Similarly, there is a deduction – albeit not a credit – available to folks making student loan payments. The deduction is income-based and limited to $2,500.

This brings us to step 4, tax planning strategies. One of the best things you can do is be sure you understand the general workings of our tax system. You may also consider working with a tax professional to make sure you are catching all the deductions and credits you are eligible for.

Contribute as much as you can to your 401k and, if you have one, your Health Savings Account. If you are making traditional, pre-tax 401k contributions, the amount you save reduces your taxable income. HSA contributions are also deducted from taxable income.

If you are saving for future college expenses for a child or grandchild, doing so inside a 529 college savings account might reduce your state tax bill. To find out what’s available in your state, you can check out the state tax calculation on the website savingforcollege.com.

Whenever possible, try to bundle expenses in the same tax year if you are close to exceeding the standard deduction amount with your itemized expenses. For example, you might make two years of charitable contributions or postpone elective medical expenses to the same year.

if you invest outside of your 401k and IRA accounts, you might talk to your financial advisor about tax loss harvesting. This is an exercise where you sell investments that have lost value in order to offset capital gains created by other investments.

Also, talk to your tax professional about some of the “above the line” deductions available to identify any that apply to you. Examples include (click and read)

This is a lot of ground to cover but I hope it was a good basic introduction to our tax system. Don’t stop here. Keep your MoneyNav financial wellness journey going.

If you haven’t already done so, a great next step is to complete your MoneyNav assessment. The assessment takes about 5 minutes and results in a series of To Dos or Money Moves built into your personalized MyMoneyNav dashboard. For a link to your employer’s assessment, email yourfinancialcoach@moneynav.com.

Of course, we also encourage you to schedule a 1:1 session with a MoneyNav coach at any time.

And we hope you will continue to join us on Mondays. You can also find other MoneyMonday workshops when you visit the MoneyNav YouTube channel. You can also connect with us on Facebook, Twitter, and YouTube for announcements about upcoming sessions and links to post-session recordings.

On behalf of the entire MoneyNav team, thanks for joining me! On behalf of the entire MoneyNav team, thanks for spending time with me today. If you have any questions or what to chat about your situation, just reach out. We look forward to connecting with you.