Financial Planning 101: Part 5
Controlling Your Tax Burden
by Gerald Townsend, Financial Editor
May 2009
It was in the 1934 Gregory v. Helvering case that Judge Learned Hand issued his well-known statement regarding income taxes:
"Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any?public duty to pay more than the law demands."
In other words, there is nothing immoral or illegal with implementing strategies to control your income tax burden. The challenge today is that taxes are so complex, by the time you complete your tax return you don’t know if you are a crook or a martyr!
This month we will examine ways reduce the DREAD of income taxes:
Deduct
Every year, due to ignorance or the fear of being audited, many taxpayers do not claim all the deductions on their tax return that they are entitled to claim. Some examples: medical expenses you pay for a certain relatives who are not your dependents (parents, siblings, aunt, etc.); home office expenses; bad debt losses; previous year’s state income taxes paid; foreign taxes paid by your mutual funds; investment fees, etc. Take the time to find every legal deduction you are qualified for.
Revise
In our federal tax system, the highest taxed income is "ordinary" income and the lowest taxed is "qualified dividend" or "capital gain" income. Therefore, it makes sense to revise — or convert — as much of your income as possible from ordinary (with rates as high as 35%) to qualified dividend/capital gain income (with rates from zero to 15%). Of course, this is easier said than done, and may not be possible with much of your income, but everyone can do this to some degree.
Investors can choose between assets that generate ordinary income (CDs and bonds) vs. assets generating qualified dividend/capital gain income (stocks). Suppose you made an investment a few months ago that has appreciated substantially. If you sell it now, your gain will be taxed at ordinary rates, but if you wait until you have owned it at least a year, you will receive the lower capital gain rate.
Exempt
Even better than revising income to capital gains is receiving income that is totally exempt from income tax. Municipal bonds are free of federal income taxes and if issued by a North Carolina city or county, they are also exempt from N.C. taxes. Investments made within a Roth IRA grow without any taxes being imposed and can be withdrawn in retirement with zero income tax. Education Savings Accounts and College Savings Plans (529 Plans) are exempt from income taxes during the accumulation years as well as for any qualified distribution.
Arrange
As the Judge said, we can arrange our finances to help control our taxes. How do you do this? Your employer may provide "cafeteria" plans allowing you to deduct money from your paycheck on a "pre-tax" basis and use the money for certain insurance premiums or health-related expenses. These plans can reduce both your income and payroll taxes. If you own a small business, there are decisions (and opportunities) to consider regarding your structure (sole-proprietor or corporate), as well as the benefits your business could provide.
Defer
Finally, even if income is not being revised and isn’t exempt, the ability to defer the taxation of income is very beneficial. Retirement plans (401k, IRA, etc.) are the principal methods of deferring income. Deferring can help in two ways: First, at the time you are earning the income, you are probably in a higher income tax bracket than when you retire and withdraw the money. Second, during the years you are investing money which would have been lost to income taxes; you are effectively getting an interest-free loan from the IRS that you don’t repay until you withdraw money from your account in the future.
Smart tax planning doesn’t eliminate taxes, but it will help control your tax burden and hopefully remove the DREAD of taxes.
Gerald A. Townsend, CPA/PFS, CFP®, CFA® is president of Townsend Asset Managment Corp., a registered investment advisory firm. Email: Gerald@AssetMgr.com