Next to Federal income taxes, your biggest tax bills may come from dividend and interest income you receive, capital gains on your investments, or ordinary income taxes paid on money that could have been invested more tax efficiently.
Following are 5 ways you can lower your tax bill and pay less tax in the future.
Open a Roth IRA. Roth IRAs are funded with after-tax dollars and grow tax free for retirement. You can access your principal at any time and the investment earnings after 5 years or age 59 ½ whichever comes last.
Married taxpayers with an adjusted gross income (AGI) of under $184,000 who file jointly can contribute up to $5,500 per person per year. Plus another $1,000 if they are age 50 or older. For some couples this is up to $13,000 per year that can be contributed to an account that grows tax-free.
Single tax payers with adjusted gross incomes under $117,000 may contribute $5,500 annually to their Roth IRA, plus another $1,000 if over age 50.
Your income is too high? Consider this backdoor strategy to funding a Roth IRA.
Convert existing IRAs to Roth IRAs. This strategy doesn’t work for everyone (few of these strategies do), but if you believe you will be in a higher tax bracket in the future than you are today, you may want to convert your IRA and pay tax at today’s lower rates. Even if rates stay the same, you may be between jobs or have business losses or for some other reason be in a low (or no) tax bracket. Better to pay taxes at 10% than 39.6%, if you can pull it off.
Establish a retirement plan for your business. If you are self-employed or own a small business you can set up a Simplified Employee Pension or a qualified retirement plan for your business and reduce your current tax bill considerably. With a SEP the IRS allows you to deduct up to 25% of your net business income to a maximum of $53,000 per year.
Other retirement plans for small businesses allow for even more generous contributions. In some cases, entrepreneurs can set up their own 401(k) and pair it with a pension for a maximum pretax contribution of over $200,000 depending on your age and other factors.
For more info on retirement plans for your small business check out IRS Publication 560 or refer to this previous blog post.
Max out an HSA. Health Savings Accounts or HSAs may be a better tax shelter than even an IRA or a Roth IRA. With an HSA contributions up to the amount of your deductible are a tax deduction on this year’s tax return. Plus earnings grow tax-free. And distributions for qualified medical expenses are tax-free at any time.
Contributions to an HSA are limited to the amount of your deductible, not to exceed $6,750 for the 2016 tax year. If you are age 55 or older you can contribute an additional $1,000 as a catch-up contribution.
Be smart about inherited IRAs. Inherited IRAs are probably the biggest tax bomb that will ever drop into your lap. According to the Center for Retirement Research at Boston College, about 2/3 of American households will inherit assets from their parents with the average windfall approaching $300,000 per household.
Not all of that will be financial assets and not all financial assets are IRAs and retirement accounts. However, with trillions of dollars currently sitting in IRAs and other retirement accounts across the country there is a good chance that your future inheritance will include taxable assets like IRAs.
When you inherit an IRA the IRS says that you must take out a certain required minimum distribution also known as your RMD. The RMD must be recalculated and taken each year, but the good news is that it’s a relatively small amount and the rest of your IRA can continue to grow (mostly) tax-deferred. Stretching out your inherited IRA RMDs in this way is a great way to maximize these benefits long into the future.
Do it wrong however and KABOOM! the tax bomb goes off. Usually in your face.
If the IRA isn’t transferred to a properly titled inherited IRA it would be taxable, often all in one year. Add that to your normal taxable income for the year and you could quickly be in the top tax brackets paying the maximum tax bill. Imagine half your inheritance going to pay income taxes. That’s a problem.
Next steps. That’s just five ways to pay less tax in the future. There is a lot more that you may be able to do to reduce your tax bill.
Talk to your tax professional and schedule an appointment with your financial advisor to discuss what your next move should be.