Who likes paying taxes?
As Arthur Godfrey once said, “I’m proud to be an American and pay taxes but I could be just as proud for half the money.”
The first strategy to lower one’s taxes is Tax Loss Harvesting
Let’s walk through how this can work for you.
If you bought a stock, stock or bond mutual fund or ETF (Exchange Traded Fund), and 12 months or more has passed and the value of this investment has decreased, you can sell up to $3,000 of losses and deduct that from your ordinary income. The other option is to offset a gain with a loss.
Let’s say 13 months ago you bought two stocks. Stock A for $8,000 and Stock B for $6,000. Now, Stock A is worth $4,000 ($4,000 less than what you paid for it) and Stock B is worth $10,000 ($4,000 more than what you paid for it). If you sold both stocks, it would come out to a net zero. No gain and no loss. (If you wanted to keep Stock B, you could just sell Stock A up to a $3,000 loss and use that loss off of your ordinary income). The remaining $1,000 loss could be carried into the next year.
What if I have a $200,000 loss? I can deduct the $3,000 this year but what happens to the other $197,000 of losses?
They can either be carried forward each year in the amount of $3,000 to offset ordinary income each year until used up, or can be used to offset long term capital gains.
Let’s say you sold a rental property or stock down the road that had a large gain, you could use that large loss from before to offset that big gain.
There are rules when taking a loss. One being, you can’t buy that same investment (or identical) within 30 days without being subject to the Wash-Sale Rule.
Here’s how the Wash Sale rule works. You sell Company A stock and have a long term loss. This can be used as explained above to either offset ordinary income of up to $3,000 a year or to offset a long term capital loss.
But, what if I like Company A stock and want to continue owning it? The Wash Sale Rule says you have to wait more than 30 days to buy that same stock back, or you cannot take the loss.
So, one has a couple of options. Wait more than 30 days or buy something similar.
Key points to consider!
Here is where it can get tricky. Let’s say you sold an index fund ABC from Company A and then bought a similar index fund XYZ from Company B. That maneuver could run afoul of the Wash Sale Rule as they can be considered the same security. This is known in the industry as a “substantially identical” security.
Another trap some have fallen into is selling Company A it their Individual account and then before 30 days, buying it in their joint account or IRA. This is not allowed
One other very important note is Tax Loss Harvesting only works in a taxable account like an individual account, joint account, or a trust.
Assets sold in a retirement account such as an IRA have no tax advantages.
Are there any other reasons one should consider selling an investment at a loss besides the potential tax savings?
Yes, there can be. Diane* came to us last year after her divorce was final and the investments in her individual account (This was a joint account initially but got split in half during the divorce) did not match her risk tolerance or her personal feelings toward some of the companies she owned.
Because some of these investments she owned had gains and some had losses, it allowed us to look at Tax Loss Harvesting as a way to sell the companies that weren’t a good fit for her while minimizing her taxes.
To learn more about Tax Loss Harvesting, give us a call or click on my link HERE
#2. Contribute money into your 401k or other retirement plan at work
For the 2023 tax year, one can contribute up to $22,500 (Up to $30,000 if one is 50 or over) into their 401k or 403b.
If making pretax contributions into your plan, these lower your taxable income and therefore lower your taxable income.
If you haven’t maxed out your plan at work, and can afford to do so, consider upping contributions from your remaining paychecks.
Many plans today have an option to make a contribution into the Roth portion. This has no impact on lowering your taxable income now, however, it allows for tax free growth and unlike a traditional 401K, has no requirement for distributions later on and lastly, if you take money out of the Roth 401k under certain conditions, no taxes are due.
Rick’s Tip! Work with your tax preparer or Certified Financial Planner™ practitioner to determine if it makes sense to contribute a certain percentage to the Roth 401k (403b) side. Even though there may not be an immediate tax benefit now, the option of tax-free growth and tax-free withdrawals might be compelling.
#3. Contribute money into a deductible IRA
If one is under 50, the maximum one can contribute in 2023 is $6,500 ($7,500 if over 50). There are guidelines whether one can deduct the contribution if one has a retirement plan at work. There are also rules if your spouse has a retirement plan at work so check with your advisor before making these types of contributions.
Rick’s Tip! If you are eligible to make an IRA contribution and you file jointly and your spouse doesn’t have earned income, you can make a contribution into their IRA. The same rule applies for Roth IRA’s. Much like the Roth 401K, there is no tax deduction now, but it does allow for tax-free growth and tax-free distributions (Assuming certain rules are met).
Lastly, unlike most retirement plans, an IRA allows for a contribution in the following year for the previous tax year. One has up until tax filing day 2024 to make a contribution for 2023.
#4. Contribute to a Flexible Spending Account (FSA)
If your employer offers an FSA, this can be yet another way to lower your tax burden. Let’s say you think your out-of-pocket medical expenses will total $6,000 this year. You can set aside from your pay (on a pre-tax basis) up to $3,050 toward these medical costs. If you file jointly and your spouse has an FSA at their job, they can also put in up to $3,050 for 2023. Kid needs braces?, you need prescription glasses?, big bottle of Advil, or have a co pay coming up? These all are eligible expenses.
Rick’s Tip! Since money left in an FSA at year end is subject to forfeiture, it is best to not max this out unless you know you will have bills that exceed the amount you put away. If December 31st is approaching and you haven’t emptied out your account, you can stock up on things like masks or hand sanitizer and chiropractic or acupuncture, counseling, contraceptives, hearing aids, and even orthotics.
#5. If you have a High Deductible Health Plan, you may be eligible to contribute to a Health Savings Account or HSA. This allows one to put away up to $3,850 ($4,850 if 55 or older) and for a family, $7,750 or ($8,750 if 55 or older). If you are approaching age 65, be careful before contributing to an HSA as that could come with penalties.
HSA’s give one the unique ability to deduct the contribution, allows for tax-free growth, and lastly, if used for qualified expenses, the money comes out tax-free. Also, unlike an FSA, there is not the same time limit on when the money has to come out. An HSA allows one to invest these contributions for potentially decades before taking the money out.
#6. If making a charitable donation, do it in the most tax advantaged way
If one is gifting a somewhat small amount to a charity, writing a check works fine. However, when making a sizeable gift, there can be better ways to give. Here are just two examples. A third could be donating appreciated securities that you were thinking of selling during your life.
A. A Qualified Charitable Distribution (QCD) allows one that is over 70 ½ to make a contribution from their IRA and therefore, avoid paying tax on the distribution since the gift goes directly to the charity. There is a certain protocol in making these gifts so please check with us or your CPA before doing this. If you have not take your Required Minimum Distribution yet for 2023 and don’t need the distribution, consider a QCD if you are charitably inclined.
B. A Donor Advised Fund (DFA) allows one to contribute a large amount in one tax year to a DAF and then dole it out as you see fit to as many charities as you like. This strategy allows you to deduct quite a bit of income in one year while staying true to how you want to gift over time.
When might one utilize a DAF? Let’s say Mortimer* receives a large bonus of $300,000 from his job. This bonus is subject to ordinary income taxes and most likely is putting him into a higher tax bracket. By establishing a DAF and donating a large sum into it for future gifts, this can help offset income and thereby reduce his taxable income for the year.
Key point! Once money is put into a DAF, it cannot come back out. Determine carefully if a DAF is right for you and how much you want to contribute. Since contributions can be made ongoing, if unsure, it may be best to donate in stages.
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In good health.
All the best.
Rick Fingerman, CFP®
*Not her real name
Financial Planning Solutions, LLC (FPS) is a Registered Investment Advisor. Financial Planning Solutions, LLC (FPS) provides this blog for informational and educational purposes only. Nothing in this blog should be considered investment, tax, health, or legal advice. FPS only renders personalized advice to each client. Information herein includes opinions and source information that is believed to be reliable. However, such information may not be independently verified by FPS.