As we head into the holiday season, many of us are thinking about the gifts we’ll buy and the feasts we’ll eat. But we also need to turn our thoughts to our finances! Every November, it’s a good idea to plan and execute year-end financial moves. 2022 is one of the most crucial years we’ll ever see!
We’re in a very efficient tax window right now, which will go away at the end of 2025 if Congress doesn’t act to extend the Tax Cuts and Jobs Act. This gives us four short years, including 2022, to execute strategic tax planning. A good tax strategy is vital to maximizing your retirement nest egg, but all too often it’s not given the priority it needs. I’ve compiled several tax strategy ideas to get you started.
One move to seriously consider is harvesting gains and losses. Almost everyone has taken a loss this year; there has been nowhere to hide from market losses. On the surface, that’s terrible news. However, if you dig deeper, there are ways to take advantage of it.
Many of our clients at Asset Preservation Wealth & Tax own long-term hold stocks such as Microsoft or UPS. They own concentrated positions in such stocks, and while it’s a good idea to diversify, there’s a key factor that holds people back from divesting long-term holds. They’re often reluctant to sell them because of the capital gains those stocks have made over the years; they don’t want to pay the taxes if they realize those gains!
That’s understandable, but sometimes it’s wise to consider a perspective shift: The market has lost about 30% this year. Are you willing to lose 30% of an asset’s value to avoid paying a 15% capital gains tax? If you play some of those gains against the losses we’ve experienced this year, you can reduce, or in some cases eliminate, capital gains taxes. This would allow you to diversify without having to pay a large tax penalty.
Consider Your Tax Bracket
The Tax Cuts and Jobs Act created an interesting tax ladder in which every other step is a very small jump. For instance, if you’re a single filer and have $80,000 in taxable income for the year, you’ll be in the 22% tax bracket. If you change jobs or get a raise the next year and have $157,500 in taxable income, your tax rate will only increase by two percent.
If, on the other hand, you’re already in that higher tax bracket and then make more than $157,500, your tax rate jumps from 24% all the way to 32%! We try to keep our clients from having to make those large jumps unless there’s a compelling justification for it.
November is famous for the Thanksgiving holiday, but I think it should also be known as Roth Conversion Month. The last few months of the year are a great time to consider converting your traditional retirement accounts to their Roth counterparts. You’ll pay income taxes on what you contribute now, but any gains the Roths make are tax-free, as are withdrawals in retirement.
Roth conversions are a good idea if you think you’ll pay more in taxes on gains and withdrawals from your traditional retirement accounts than you would if you converted them to Roths now. However, there’s an important aspect of Roth conversions you need to consider.
You’ll pay income taxes on what you contribute now because contributions to Roth retirement accounts are taxed as ordinary income. That means Roth conversions can cause you to jump into a higher tax bracket.
If that jump is one of the small ones such as 22% to 24%, it’s much less burdensome than if that jump is a large one such as 24% to 32%. You don’t want to be tax-savvy by converting to a Roth only to get surprised by a massive jump in owed income tax!
Some people have the opposite problem. They’re reluctant to convert to Roths because they want to have no income for tax purposes. But that can be wasteful. The standard deduction in 2022 for married couples filing jointly is $25,900. That means you don't have to maintain zero income in order to avoid income taxes; you can take in nearly $26,000! Why bypass that tax break by being reluctant to convert to a Roth based on taxable income?
On the other hand, people worried about jumping tax brackets often avoid converting to Roths, but they could be setting themselves up with a ticking tax time bomb. Once you reach age 72, you have to start taking required minimum distributions from your IRAs. If you’re married and filing jointly, and those RMDs bring you above $32,000 in income for the year, you’ll have to start paying taxes on Social Security and income tax on your distributions. Since Roth accounts don’t have RMDs for the original owner, you avoid that tax bomb.
Each Situation is Unique
After reading this, you might be thinking it’s a great idea to perform Roth conversions every year as long as you’re only subject to a small tax bracket jump. But as is often the case in finance, it depends on your individual circumstances.
Even a small jump from 22% to 24% can end up costing you because there’s a land mine hiding in that part of the tax ladder. The Income-Related Monthly Adjustment Amount, or IRMAA, is a surcharge on Medicare premiums that people with high incomes must pay. What you pay in a given year is based on your tax return from two years before. That means too much income at age 63 can cost you a lot of surprise premiums when you sign up for Medicare.
There are other tax land mines to be watchful for as well, which is why it’s important to work with a financial planner if you can. We have specialized software that’s too expensive for most individuals to justify.
That software allows us to simulate tax returns for many scenarios to find the most prudent way forward. People without access to that information have to tiptoe through the minefield on their own, hoping they don’t set one off.
Complicated but Needed
End-of-year finance moves are as complex as they are necessary. It’s very important, if you can, to work with a financial planner to determine the most prudent moves to make based on your individual circumstances. If you aren’t able to work with a financial advisor, that doesn’t mean you should give up. There are still moves to make, such as those we’ve just explained, that can enhance your financial position now and in retirement.
Stewart Willis is the founder and president of Asset Preservation Wealth & Tax, a financial planning firm in Phoenix, Arizona. Investment advisory services offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.