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Year-End Tax Planning

Perspective Matters

There are a few things to review between now and the end of the year to make decisions about tax planning for 2023 and 2024. At this point most people should be able to reasonably estimate what their taxable income will be for the year and there are certain strategies that may make sense to consider depending on where your marginal tax rate falls. 

The first big thing to pay attention to is whether you have to take a distribution from an IRA, either your own or one on which you are a beneficiary. If you were born on or before July 1, 1949, you definitely must take a distribution from your own IRA, unless you qualify for an exemption because you are still working. Traditional IRA owners are subject to RMDs beginning in the year in which they turn 73 but the rules have changed twice in a three year period. The SECURE Act raised the age to 72 for anyone who turned 70 ½ in 2020 or later. The SECURE 2.0 raised it to 73 for those who turn 72 in 2023 or later. 

If you are the beneficiary on an Inherited IRA, the rules you are subject to depend on when the IRA owner died, and whether or not they had started RMDs. If the IRA owner died before 2020, you are subject to the old rules for “stretch” IRAs and must take a distribution. Your calculation of how much is based on how old you were when the IRA owner died. There are resources HERE to see which rules apply to you. Consider consulting your tax adviser or financial planner or reach out to a Certified Financial Planner® or a member of the Ed Slott Master Elite IRA Advisor Group to see whether you should take a distribution before December 31. 

Before I go further, I want to clarify some language. I find it helpful to start by defining a couple of terms because too often we use certain things interchangeably that have very different meanings, and when we're thinking about tactical moves to make such as converting pretax IRA money into a Roth IRA, the difference between these terms could lead to either a very valuable or very expensive decision. 

The thing I want to focus most on first is the difference between marginal and effective tax rates. The income tax system in the United States is progressive. That means that as your income goes up there are thresholds above which the next dollar of taxable income is taxed at a higher rate than the previous dollar. Your marginal rate refers to the tax rate on your next dollar of earnings. Your effective tax rate is a blended rate, and we calculate it by taking the total dollar amount of your tax liability and dividing it by your gross income before any deductions or credits. In different situations the effective tax rate may be calculated differently but to me this is the simplest way to think about it.  

Let's keep it simple for the purpose of illustration. For example, let's say you are not married, and you have a salary of $80,000 exactly. That means like most Americans today you do not itemize your deductions. The standard deduction for a single person under the age of 65 is $13,850 in 2023. If you subtract that from your salary that makes your taxable income $66,150. 

As a single person the first $11,000 of your taxable income is subject to federal income taxes at a 10% rate. The next $34,725 of taxable income is subject to a federal income tax rate of 12% and the next $50,650 is taxed at a federal rate of 22%. So, the top income level of the 22% marginal rate for a single person in 2023 is $95,375. 

Since your taxable income is $66,150 your total tax liability is approximately $9861. Please keep in mind that I am not providing formal tax advice; my purpose here is to educate on how our tax system works. If you have questions about your own tax situation you should consult a tax professional. Also, I am focusing only on federal income taxes here; you may also be subject to additional state and local income taxes which is beyond the scope of what I'm writing about today. 

Going back to our example - $9861 of taxes due on an $80,000 salary works out to an effective tax rate of about 12.3%. So, your marginal tax rate is 22% but your effective tax rate is just over 12%. Since your taxable income is $66,150 and the top end of the 22% tax bracket is $95,375 in 2023 that means you could generate an additional $29,225 of taxable income before moving into the next marginal rate of 24%. If your taxable income was exactly equal to the maximum of that 22% marginal rate of $95,375 your total federal income tax would be approximately $16,290, which would give you an effective tax rate of just under 15%. Even though the next dollar of income would be taxed at 24% you are your effective tax rate is just under 15%. 

I started with talking about marginal versus effective tax rates because one thing you can still do in 2023 is a Roth conversion. A Roth conversion is the process of taking money from a pretax IRA or 401K and moving it into a Roth IRA or Roth 401K. Moving it creates A taxable event which means the amount you move gets added to your income for the year in which you make the transfer. By moving it directly you avoid any early withdrawal penalties you might otherwise have on taking money out of a pretax account. Before doing a Roth conversion make sure you speak with a tax advisor who can look at your situation and give you more accurate and precise information about how much you could move and stay within the same marginal tax rate and what the income taxes could be on the amount you convert. 

Usually, a Roth conversion makes the most sense when you have cash from someplace else to pay the taxes due. 

Another thing to consider before the end of 2023 is contributions to a 529 plan. Many states offer an income tax deduction for contributions made to 529 plans. There may be limits on these contributions so look into the details of your 529 plan. If your state allows a deduction for contributions, they probably need to be made before the end of the year. 

Gifting using the annual gift exclusion is another type of contribution to consider before the end of December. You are allowed to make an unlimited number of gifts up to the annual gift tax exclusion ($17,000 in 2023,) but they must be completed by year end if you want to use the exclusion. In my opinion, the gift recipient should deposit the check so that it clears your account before December 31st. Using the annual gift exclusion can be a way to reduce your taxable estate and transfer money between friends and family without tax implication. Again, there are some other rules that may apply to your situation so make sure you consult a tax advisor about your specific situation. 

Next is tax gain and loss harvesting. Tax loss harvesting means looking at the investments you own in your taxable accounts. If any of them are worth less than when you bought them, you may be able to sell them and use the losses to reduce your income on your tax return in 2023. You may also be able to use realized losses to offset any realized gains, including distributions from mutual funds that you may own. Many mutual funds that own stocks make distributions in December that create capital gains for your tax return. Being mindful of your opportunity to generate tax losses can help offset the impact of those capital gains distributions. 

Tax gain harvesting is selling investments at a profit when you fall into the tax bracket with a 0% Long Term Capital Gains tax rate, then repurchasing them and establishing a higher cost basis. A single tax filer with taxable income less than about $44,000 may be in a 0% Long Term Capital Gains tax bracket. The threshold for people who are married and filing jointly is about $89,000.  

In order to use any tax gain or loss transaction you have to follow certain rules. For tax losses you may not have a purchase transaction in the 61 day window that begins 30 days before you sell and ends 30 days after you've sold. You don't have that window for harvesting tax gains, but remember that your gains will count towards certain calculations in your tax returns so it's always better to check with a tax advisor before implementing either a tax gain or tax loss strategy. 

You also should consider checking that your estimated taxes or tax withholdings are adequate for 2023 to avoid penalties for under payments. You can go to the IRS website and use the free tool there to see if you've had enough taxes withheld from your income or made enough estimated payments so that you won't be facing penalties come April.  This may apply to you if: 

  • You have older dependents on your tax return including children aged 17 or older.

  • You had credits on your tax return in 2022 and you may not be eligible for the same credits in 2023.

  • You itemized deductions on your 2022 tax return (will they be different for 2023?)

  • You earn a relatively high income and have a complex tax return.

  • You report a large amount of investment income that can vary from one year to the next.

  • You had a large tax bill for 2022 or received a large tax refund.

If you do the math and discover that you may not have had enough taxes paid you have time to make an estimated payment before the end of 2023. It's easy to go to the IRS website and make a payment for the current year. You can also increase your withholdings from your salary or retirement account distributions. Estimated payments will be treated as paid when you pay them, whereas changing withholdings from salary or retirement accounts would be treated as if those rates held throughout the year. This could help reduce any potential penalty for underpayment. 

The recent SECURE Act legislation has a list of provisions coming into effect in 2024. In a future column I’ll write about some of them, such as 529-to-Roth IRA transfers and expanded exceptions to the 10% early withdrawals penalties for IRAs. For now, think about what you can do now to affect 2023, and budget some time in early 2024 to meet with your tax advisor and Certified Financial Planner® so you’ll know how these changes will affect you. 

Neither Prism Planning and Solutions Group nor Insight Advisors provide tax advice, and nothing in this communication should be treated as such. This communication should not be interpreted as a recommendation for a specific investment or tax-planning strategy. We are providing this material for informational purposes only. We have made every attempt to verify that information contained in this communication is accurate as of the date published but make no warranties. Before making any decisions related to your own tax and/or investment situation you should consult the appropriate professionals.   

Certified Financial Planner Board of Standards, Inc. (CFP Board) owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® (with plaque design) in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.


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