Everyone should use the favorable features of the tax code to minimize their tax liability. Even people who read widely about personal finance may be uninformed of potential benefits.
Here are some common savings that many overlook:
Charitable giving from a retirement account
If you have reached 70 1/2 and invest in traditional retirement plans, you are required to make required taxable minimum distributions each year. If you make contributions to qualified charities and don't itemize, you can reduce your taxes. You can have the trustee of your traditional retirement plan make a direct transfer to a qualified charity. If the contribution does not exceed $100,000, the transfer is not taxable.
For example, if you contribute $1,000, and your marginal tax bracket is 28 percent, the saving to you would be $280 (the result of multiplying the contribution by your marginal tax bracket.)
If you are required to make RMDs because of your age, you can take advantage of a Qualified Longevity Annuity Contract. In 2014, the Treasury Department and the IRS approved the use of this type of annuity. It can be used with a traditional IRA, 401(k), 403(b) or 457(b) plan.
A longevity annuity is a fixed annuity that guarantees you income at a future date, not later than age 85. (If you die before then, your beneficiaries would receive the initial investment.) The amount you invest reduces the amount used by the IRS to compute your RMD. The limit of the amount is 25 percent of the value of the account, or $125,000, whichever is less.
Annuity expert Stan Haithcock gives this example: If the value of the account was $500,000, an investment of $125,000 in a QLAC would reduce the basis of the RMD computation to $375,000 and reduce your taxable income by approximately $4,500 in the first year alone. The annuity allows you to maintain a larger balance in the account for a longer period because your mandatory withdrawal is reduced, and you obtain tax deferral on the larger balance.
Many families do not take advantage of establishing and making contributions to spouses who either don't work or have low earnings. For example, for a 2016 tax return, a family filing a joint return can contribute $5,500 ($6,500 if older than 50) to each spouse as long as the adjusted gross income does not exceed $98,000, and the combined earned income is at least $11,000.
Roth spousal accounts can also be established for non-working spouses consistent with IRS income constraints.
Retirement accounts for alimony recipients
If you receive alimony, it is considered “earned income” by the IRS. This means that, even if you have no other earned income, you can still establish and contribute to traditional IRAs and Roth IRAs. Many individuals who receive alimony do not establish retirement accounts.
Calculating the basis of investments properly
Some investors overpay their taxes because they fail to compute their tax liability correctly regarding the sale of investments.
For example, assume an investor invested $5,000 in a mutual fund. Over five years he or she received $2,000 in dividends and capital gains, and reinvested these proceeds into that fund. Five years later, he or she sells their shares for $9,000. If they reported a gain of $4,000 they would be over-paying their taxes. The basis was $7,000, not $5,000, because each year he or she would have received a statement from the broker/mutual fund informing them to pay taxes on $2,000 received.
Assuming the investor did report those proceeds in accordance with IRS regulations, the basis in the investment would be $7,000, the initial investment plus the $2,000 received in dividends and capital gains. Unfortunately some investors don't keep proper records, and as a result they compute their basis improperly and over-pay their income taxes.
Many investors don't take all the deductions and tax breaks they are entitled to. A good source that identifies them is “J.K. Lasser's 1001 Deductions and Tax Breaks 2017” by Barbara Weltman (Wiley).
Elliot Raphaelson welcomes your questions and comments at firstname.lastname@example.org.